Bootstrapping Effect – Example

Assume two companies are planning a merger – the following figures are given:

A T

Stock Price 100 50

EPS 4 2.5

P/E 25 20

Outstanding shares

100,000 50,000

Total earnings 400,000 125,000

MV 10,000,000 2,500,000

Steps:

In order to know the number of shares that need to be issued: 2,500,000/100 = 25,000

Total shares of both company = 100,000 + 25,000 = 125,000 Total earnings = 400,000 + 125,000 = 525,000 New EPS of post-merger = 525,000/125,000 = $4.2

If the market is efficient, the post-merger P/E should adjust to the weighted average of EARNINGS contributions of both companies. This means:

New P/E = 400,000/525,000 * 25 + 125,000/525,000 * 20 = 23.8 Price = 23.8 * 4.2 = $100

If investors apply the pre-merger P/E of 25x, then price would increase to 4.2 * 25 = 105

What are the methods to be used in Merger Analysis?

Target Company Valuation

First: DFC

The discounted cash flow analysis is one way to value a merger by discounting the company’s expected future free cash flows in order to derive the value of the company. FCF estimation has been covered in a detailed topic in the equity investments section. In summary, however, FCF can be estimated as:

When evaluating the target from a non-control perspective, we should use the target’s WACC. Finding the terminal value can be found in one of two ways:

(1) Constant growth rate; that is:

(2) Applying a multiple at which the analyst expects the average company to sell at the end of the first stage.

Second: Comparable Company Analysis

The analyst first defines a set of other companies that are similar to the target under review. The next step is to calculate various relative value measures based on the current market prices. After finding the mean/median of the multiples and apply it to the target company, we would be able to find the stock price. Up to this point, we have determined the stock price. In order to calculate an acquisition value, the analyst must also estimate a takeover premium which is the amount by which the takeover price for each share must exceed the current stock price in order to entice shareholders to relinquish control of the company to an acquirer.

Where PRM is the takeover premium (as percentage of stock price), DP is the deal price and SP is the stock price.

The following example shows a very simplified illustration of the method. Assuming that the ABC Company is trying to analyze the fair value of XYZ in order to determine the acquisition price, using comparable company analysis, ABC has determined two comparable companies and the following valuation variables:

Valuation Variable

Company 1 Company 2

Current Stock Price

20 15

EPS 2 1.67

BVPS 8 5

We can find the following multiples

Multiple Company 1 Company 2 Mean

P/E 20/2 = 10 15/1.67 = 9 9.5

P/BV 20/8 = 2.5 15/5 = 3 2.75

If XYZ has EPS of 2.5 and BVPS of 7 then applying the mean multiples:

Variable Target Company

Mean Multiple

Estimated Stock Price

EPS 2.5 9.5 2.5 * 9.5 =23.75

BVPS 7 2.75 7 * 2.75 = 19.25

The mean stock price is then 21.5; Now, we need to add the takeover premium. We estimate it from 3 transactions (recent takeovers) in companies in the same industry

Target Company

Stock Price Before Takeover

Takeover Price

Takeover Premium (%)

Target 1 20 25 25%

Target 2 15 20 33.33%

Target 3 30 36 20%

MEAN 26.11%

Therefore, the estimated takeover price for the target is 21.5 * 1.2611 = 27.11

Third: Comparable Transaction Analysis]

Similar to comparable company analysis except that the analyst uses details from recent takeover transactions for comparable companies to make direct estimates of the target company’s takeover value. For this approach, we compare multiples actually paid for similar companies in other M&A deals. Therefore, there is no need to estimate the premium.

he following example shows a very simplified illustration of the method. Assuming that the ABC Company is trying to analyze the fair value of XYZ in order to determine the acquisition price, using comparable company analysis, ABC has determined two comparable acquired companies and the following valuation variables:

Valuation Variable

Acquired Company 1

Acquired Company 2

Acquisition Price 20 15

EPS 2 1.67

BVPS 8 5

We can find the following multiples

Multiple Acquired Company 1

Acquired Company 2

Mean

P/E 20/2 = 10 15/1.67 = 9 9.5

P/BV 20/8 = 2.5 15/5 = 3 2.75

If XYZ has EPS of 2.5 and BVPS of 7 then applying the mean multiples:

Variable Target Company Mean Multiple Estimated Stock Price

EPS 2.5 9.5 2.5 * 9.5 =23.75

BVPS 7 2.75 7 * 2.75 = 19.25

If the analyst determines equal weighting for each multiple (50% for each) then the mean stock price is then 21.5. If the analyst thinks that earnings are more important determinant of value, he could assign a weight of 60% to it and 40% to book value and the estimate stock price will be 0.6 * 23.75 + 0.4 * 19.25 = 21.95

Bid Evaluation

Assessing the target’s value is important but it is insufficient for an assessment of the deal.

When evaluating a bid, the pre-merger value of the target company is the minimum value that target shareholders should expect. The maximum that acquirer’s should pay on the other hand is pre-merger value of target company plus expected synergies or else there will be reduction in value.

Illustration for Bid Evaluation Method:

Acquirer Target

Pre-merger stock price 15 10

Outstanding share (in millions)

75 30

Pre-merger market value (in millions)

1125 300

The expected synergy = 90 million

Option 1: Cash offer of $12 per share

PT = 12 * 30 = 360 Premium = PT – VT = 360 – 300 = 60 million Acquirer’s again = 90 – 60 = 30 million Post-merger value = 1125 + 300 + 90 – 360 = 1155 million Acquirer’s again = 1155 – 1125 = 30 million Post-merger price = 1155/75 = 15.4

Option 2: Stock offer of 0.8 shares of A’s stock per share of T’s stock

Number of stocks = 0.8 * 30 = 24 Post-merger value = 1125 + 300 + 90 – 0 = 1515 million Post-merger price = 1515/(75+24) = 15.3 Price paid = 15.3 * 24 = 367 Premium = PT – VT = 367 – 300 = 67 million Acquirer’s again = 90 – 67 = 23 million

Option 3: Mixed offer of $6 plus 0.4 shares of A’s stock per share of T’s stock

Number of stocks = 0.4 * 30 = 12 Post-merger value = 1125 + 300 + 90 – 6(30) = 1335 million Post-merger price = 1335/(75+12) = 15.35 Price paid = 15.35 * 12 + 180 = 364 Premium = PT – VT = 364 – 300 = 64 million Acquirer’s again = 90 – 64 = 26 million

Q: The target firm has 10 million shares outstanding at a price of $9.00 per share. What should the offering price be?

The acquirer estimates the maximum price they would be willing to pay by dividing the target’s value by its number of shares:

Max price = Target’s value / # of shares

= $163.9 million / 10 million

= $16.39

Offering range is between $9 and $16.39 per share.

The offer could range from $9 to $16.39 per share.

At $9 all the merger benefits would go to the acquirer’s shareholders.

At $16.39, all value added would go to the target’s shareholders.

Acquiring and target firms must decide how much wealth they are willing to forego.

Q: Merger analysis: Post-merger cash flow statements

REQUIRED:

What is the appropriate discount rate to apply to the target’s cash flows? Determine terminal value

2003 2004 2005 2006Net sales $60.0 $90.0 $112.5 $127.5- Cost of goods sold 36.0 54.0 67.5

76.5- Selling/admin. exp. 4.5 6.0 7.5

9.0- Interest expense 3.0 4.5 4.5

6.0EBT 16.5 25.5 33.0 36.0- Taxes 6.6 10.2 13.2 14.4Net Income 9.9 15.3 19.8 21.6

Retentions 0.0 7.5 6.0 4.5Cash flow 9.9 7.8 13.8 17.1

What are the Motives for Mergers?

There are many motivations behind mergers such as:

1. Synergy: it refers to the concept that the whole of the combined company will be worth more

than the sum of its parts. Cost synergies typically achieved through economies of scale and

revenue synergies are created through cross-selling of products, expanded market share, and

increasing prices because of lowering competition

2. Growth: Companies can grow either by making investments internally (i.e. organic growth) or

by buying the necessary resources externally (i.e. external growth – faster to be done and less

risky because of familiarity with business)

3. Increasing market power: when a company increases its market power through horizontal

mergers, it may have greater ability to influence market prices. Taken to an extreme, horizontal

integration results in a monopoly

4. Acquiring unique capabilities and resources: Many companies undertake a merger or an

acquisition either to pursue competitive advantages or to shore up lacking resources

5. Diversification: If diversified, the variability of the conglomerate cash flows is reduced (at

least to the extent that cash flows are uncorrelated). Although this may seem like a rational

motive, it has been challenged: (1) in a well-functioning markets, shareholders can diversify

their own portfolios and (2) the desire to diversify makes companies lose sight of their major

competitive strengths

6. Bootstrapping earnings: when a company’s earnings increases as a consequence of merger

transaction itself (rather than because of resulting economic benefits), it is referred to as

“bootstrap effect.” For this to happen, the acquirer’s P/E must be higher than the target’s P/E –

I will refer to an example in a while

Find the appropriate discount ratekS(Target) = kRF + (kM – kRF)βTarget

= 9% + (4%)(1.3) = 14.2%Determine terminal valueTV2006 = CF2006(1 + g) / (kS – g)

= $17.1 (1.06) / (0.142 – 0.06)

=$221.0 million

7. Manager’s personal incentives: Managerialism theories posit that because executive

compensation is highly correlated with company size, corporate executives are motivated to

engage in mergers to maximize the size of their company rather than shareholder value. Also,

being the senior executive of a larger company conveys more power and prestige

8. Tax considerations: It is possible for a profitable acquirer to benefit from merging with a

target that has accumulated a large amount of tax losses

9. Unlocking hidden value: when a potential target is underperforming, an acquirer may believe

it can acquire the company cheaply and then unlock hidden values. It can actually acquire it for

less than breakup value (i.e. the value that can be achieved if company assets are sold

separately)

10. Cross-border motivations: cross-border mergers can provide an efficient way of achieving

other international business goals: exploiting market imperfections, overcoming adverse

government policy, technology transfer, product differentiation, and following clients.