Chapter 10 Mergers and Acquisitions

Chapter 10Mergers and AcquisitionsPresenters namePresenters titledd Month yyyy11. IntroductionMergers and acquisitions (M&A) are complex, involving many parties.Mergers and acquisitions involve many issues, includingCorporate governance.Form of payment.Legal issues.Contractual issues.Regulatory approval.M&A analysis requires the application of valuation tools to evaluate the M&A decision. Copyright 2013 CFA Institute2Pages 408409

Introduction

Mergers and acquisitions (M&A) are complex, involving many parties.Example 10.1 Guidant Corporation (target)Johnson & Johnson (bidderunsuccessful)Boston Scientific (biddersuccessful)Note: Update on mergerBoston Scientific paid more than a half billion U.S. dollars in 2011 for improper conduct by Guidant prior to the merger, with more potential additional claims by the IRS and Department of Justice (DOJ).

Mergers and acquisitions involve many issues, includingCorporate governance (e.g., role of the board of directors).Form of payment (stock or cash).Legal and contractual issues (e.g., takeover defenses).Regulatory approval (e.g., competition).

M&A analysis requires the application of valuation tools to evaluate the M&A decision: Bid and takeover premium.Distribution of gains between acquiring firm and target firm shareholders.

2Example of a merger:AMR and U.S. Airways Copyright 2013 CFA Institute3LOS: Classify merger and acquisition (M&A) activities based on forms of integration and types of mergers.

Example of a Merger: AMR and U.S. Airways

Issues:AMR, parent of American Airlines, filed for bankruptcy on 29 November 2011.AMR and its unions (pilots, flight attendants) grappled with labor agreements that would be suitable under a merged company (reached agreements December 2012 and January 2013).FTC made a second request for a review of the merger in March 2013 under the Hart-Scott-Rodino Act.

Parties:AMRUS Airways

Regulatory authorities:Federal Trade Commission (FTC)DOJ

Discussion question: What would be the benefit to U.S. Airways shareholders of a merger with AMR?32. Mergers and acquisitions DefinitionsCopyright 2013 CFA Institute4Merger with ConsolidationAcquisitionLOS: Classify merger and acquisition (M&A) activities based on forms of integration and types of mergers.Pages 410411

2. Mergers and Acquisitions Definitions

In a consolidation, both companies terminate their legal existence and a new company arises (Company C in the diagram).Example: U.S. Airways + AMR = American Airlines Group Inc.

In a statutory merger, often referred to as an acquisition, one company ceases to exist. All of its assets and liabilities are subsumed in the acquiring party (Company X in diagram). Example: Krafts 2009 acquisition of Cadbury

In a subsidiary merger, the acquired party becomes a subsidiary of the acquiring party (not diagrammed). Example: Textrons acquisition of Cessna Aircraft Company in 19894Mergers and Acquisitions DefinitionsParties to the acquisitions:The target company (or target) is the company being acquired.The acquiring company (or acquirer) is the company acquiring the target.Classified based on endorsement of parties management:A hostile takeover is when the target company board of directors objects to a takeover offer.A friendly transaction is when the target company board of directors endorses the merger or acquisition offer.

Copyright 2013 CFA Institute5LOS: Classify merger and acquisition (M&A) activities based on forms of integration and types of mergers.Pages 410411

Mergers and Acquisitions Definitions

Parties to the acquisitions: The target company (or target) is the company being acquired.The acquiring company (or acquirer) is the company acquiring the target.Note: When you have a merger of equals, there is no clear designation of the target and acquirer.

Classified based on endorsement of parties management: A hostile takeover is when the target company board of directors objects to a takeover offer.A friendly transaction is when the target company board of directors endorses the merger or acquisition offer.Note: The distinction between a hostile merger and a friendly merger is made later in the chapter in Section 4.3.5Mergers and Acquisitions DefinitionsClassified by the relatedness of business activities of the parties to the combination:

Copyright 2013 CFA Institute6TypeCharacteristicExampleHorizontal mergerCompanies are in the same line of business, often competitors.Walt Disney Company buys Lucasfilm (October 2012).Vertical mergerCompanies are in the same line of production (e.g., suppliercustomer).Google acquired Motorola Mobility Holdings (June 2012).Conglomerate mergerCompanies are in unrelated lines of business.Berkshire Hathaway acquires Lubrizol (2011).LOS: Classify merger and acquisition (M&A) activities based on forms of integration and types of mergers.Pages 410411

Mergers and Acquisitions Definitions

Horizontal merger: Companies are in the same line of business, often competitorsfor example, Walt Disney Company buys Lucasfilm (October 2012).Vertical merger: Companies are in the same line of production (e.g., suppliercustomer)Google acquired Motorola Mobility Holdings (June 2012).Conglomerate merger: Companies are in unrelated lines of business.

63. Motives for mergerCopyright 2013 CFA Institute7LOS: Explain common motivations behind M&A activity.Pages 413417

3. Motives for Merger

Creating value (that is, mergers with these motives have the potential to add value):Synergy (Note: 1 + 1 > 2) Economies of scaleCross-product sellingGrowth External growth (may be less risky than organic growth)Increasing market power Horizontal or vertical integration to increase strength in the industryNote: Regulatory authorities in some countries may limit this as a benefit (e.g., FTC in the United States).Acquiring unique capabilities or resources Resources include patents, technology, trademarks, or raw materialsUnlocking hidden value Improve management, reorganize structure, breakups, or liquidations

Cross-border mergers: Exploiting market imperfectionsCheaper labor in one marketLower-cost raw materialsOvercoming adverse government policyCircumvent tariffsCircumvent barriers to tradeTechnology transferFacilitate entry into a countrys marketGain access to new technology or resourcesProduct differentiationEnhance product lineExpand into a countrys marketBuy reputation for entry into a marketFollowing clientsMake sure that the business of clients do not go to another company once the client expands to another country.

Dubious motives:Diversification Investors can diversify in their own portfolios, so there is generally no value to companies to diversify.Bootstrapping earnings (see Example 10-3)Occurs if the acquirers shares trade at a higher P/E than the targetsManagers personal incentives Compensation (often tied to size of the firm/earningspart of managerialism theories)Decrease their personal employment riskTax considerations Most jurisdictions do not allow buying tax losses.

Discussion question: Is there any economic justification for diversification as a motive to merge?7Example: Bootstrapping earningsCompany OneCompany TwoCompany One Post-AcquisitionEarnings$100 million$50 million$150 millionNumber of shares 100 million50 million125 millionEarnings per share$1$1$1.20P/E201020Price per share$20$10$24Market value of stock$2,000 million$500 million$3,000 millionCopyright 2013 CFA Institute8Assumptions:Exchange ratio: One share of Company One for two shares of Company TwoMarket applies pre-merger P/E of Company One to post-merger earnings.Bootstrapping earnings is the increase in earnings per share as a result of a merger, combined with the markets use of the pre-merger P/E to value post-merger EPS.LOS: Explain how earnings per share (EPS) bootstrapping works and calculate a companys post-merger EPS.Pages 415416

Example: Bootstrapping Earnings

Bootstrapping earnings is the increase in earnings per share as a result of a merger, combined with the markets use of the pre-merger P/E to value post-merger EPS. In this example, we first assume that the market is imperfect and incorrectly applies the pre-merger P/E of Company One to the merged company.In the next slide, we assume that the market correctly values the post-merger company using a weighted average P/E.Example 10-3 provides an example of the bootstrapping effect.

Discussion question: In an efficient market, would bootstrapping exist? 8Example: Bootstrapping earningsCompany OneCompany TwoCompany One Post-AcquisitionEarnings$100 million$50 million$150 millionNumber of shares 100 million50 million125 millionEarnings per share$1$1$1.20P/E201016.67Price per share$20$10$20Market value of stock$2,000 million$500 million$2,500 millionCopyright 2013 CFA Institute9Assumptions:Exchange ratio: One share of Company One for two shares of Company TwoMarket applies weighted average P/E to the post-merger company.9Motives and the Industrys Life CycleThe motives for a merger are influenced, in part, by the industrys stage in its life cycle.Factors includeNeed for capital.Need for resources.Degree of competition and the number of competitors.Growth opportunities (organic vs. external).Opportunities for synergy.

Copyright 2013 CFA Institute10LOS: Explain the relationship among merger motivations and types of mergers based on industry life cycles.Pages 417418

Motives and the Industrys Life Cycle

The motives for a merger are influenced, in part, by the industrys stage in its life cycle (Example 10-4).

Factors includeNeed for capital (e.g., startups may merge with larger firms to have access to capital).Need for resources (e.g., need for raw materials in a competitive market). Degree of competition and the number of competitors (e.g., survival for a mature company with few growth opportunities).Growth opportunities (organic vs. external)for example, mature companies may seek out external growth as organic opportunities wane.Opportunities for synergy (e.g., mature companies may need to merge to gain economics of scale to produce growth).

10Mergers and the Industry Life CycleIndustry Life Cycle StageIndustry DescriptionMotives for MergerTypes of MergersPioneering developmentIndustry exhibits substantial development costs and has low, but slowly increasing, sales growth.Younger, smaller companies may sell themselves to larger companies in mature or declining industries and look for ways to enter into a new growth industry.Young companies may look to merge with companies that allow them to pool management and capital resources.Conglomerate HorizontalRapid accelerating growthIndustry exhibits high profit margins caused by few participants in the market.Explosive growth in sales may require large capital requirements to expand existing capacity.Conglomerate HorizontalCopyright 2013 CFA Institute11LOS: Explain the relationship among merger motivations and types of mergers based on industry life cycles.Pages 417418

Mergers and the Industry Life Cycle

From Example 10-4 in the text.11Mergers and the Industry Life CycleIndustry Life Cycle StageIndustry DescriptionMotives for MergerTypes of MergersMature growthIndustry experiences a drop in the entry of new competitors, but growth potential remains.Mergers may be undertaken to achieve economies of scale, savings, and operational efficiencies.HorizontalVerticalStabilization and market maturityIndustry faces increasing competition and capacity constraints.Mergers may be undertaken to achieve economies of scale in research, production, and marketing to match the low cost and price performance of other companies (domestic and foreign).Large companies may acquire smaller companies to improve management and provide a broader financial base.HorizontalCopyright 2013 CFA Institute12LOS: Explain the relationship among merger motivations and types of mergers based on industry life cycles.Pages 417418

Mergers and the Industry Life Cycle

From Example 10-4 in the text.12Mergers and the Industry Life CycleIndustry Life Cycle StageIndustry DescriptionMotives for MergerTypes of MergersDeceleration of growth and declineIndustry faces overcapacity and eroding profit margins.Horizontal mergers may be undertaken to ensure survival. Vertical mergers may be carried out to increase efficiency and profit margins. Companies in related industries may merge to exploit synergy.Companies in this industry may acquire companies in young industries.HorizontalVerticalConglomerateCopyright 2013 CFA Institute13LOS: Explain the relationship among merger motivations and types of mergers based on industry life cycles.Pages 417418

Mergers and the Industry Life Cycle

From Example 10-4 in the text.

134. Transaction characteristicsCopyright 2013 CFA Institute14LOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management.Pages 418423

4. Transaction Characteristics

Form of the transaction Stock purchaseAsset purchaseMethod of payment CashSecuritiesCombination of cash and securitiesAttitude of management HostileFriendly

14Form of an AcquisitionIn a stock purchase, the acquirer provides cash, stock, or combination of cash and stock in exchange for the stock of the target firm.A stock purchase needs shareholder approval.Target shareholders are taxed on any gain.Acquirer assumes targets liabilities.In an asset purchase, the acquirer buys the assets of the target firm, paying the target firm directly. An asset purchase may not need shareholder approval.Acquirer likely avoids assumption of liabilities.Copyright 2013 CFA Institute15LOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management.Pages 419420

Form of an Acquisition

In a stock purchase, the acquirer provides cash, stock, or combination of cash and stock in exchange for the stock of the target firm. A stock purchase needs shareholder approval.Target shareholders are taxed on any gain.Acquirer assumes targets liabilities.

In an asset purchase, the acquirer buys the assets of the target firm, paying the target firm directly. An asset purchase may not need shareholder approval.Acquirer likely avoids assumption of liabilities.

15Method of PaymentCash offeringCash offering may be cash from existing acquirer balances or from a debt issue.Securities offeringTarget shareholders receive shares of common stock, preferred stock, or debt of the acquirer.The exchange ratio determines the number of securities received in exchange for a share of target stock.Factors influencing method of payment:Sharing of risk among the acquirer and target shareholders.Signaling by the acquiring firm.Capital structure of the acquiring firm.Copyright 2013 CFA Institute16Based on data from Mergerstat Review, 2006. FactSet Mergerstat, LLC (www.mergerstat.com).LOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management.Pages 420422

Method of Payment

Cash offeringCash offering may be cash from existing acquirer balances or from a debt issue.Securities offeringTarget shareholders receive shares of common stock, preferred stock, or debt of the acquirer.The exchange ratio determines the number of securities received in exchange for a share of target stock.Factors influencing method of payment:Sharing of risk among the acquirer and target shareholders.Signaling by the acquiring firm.Capital structure of the acquiring firm.

16Mindset of ManagersFriendly merger: Offer made through the targets board of directorsCopyright 2013 CFA Institute17Hostile merger: Offer made directly to the target shareholdersLOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management.Pages 422423

Mindset of Managers

Friendly merger: Offer made through the targets board of directorsProcess:Approach target management. Enter into merger discussions.Perform due diligence.Enter into a definitive merger agreement.Shareholders and regulators approve.

Hostile merger: Offer made directly to target shareholdersBear hug Informal offer directly to target shareholdersTender offer Formal offer made directly to the shareholders of the target firmShareholders must tender their sharesthat is, accept the offer.Proxy fight Acquiring party solicits proxies (votes).Acquiring party, with sufficient proxies, has representatives elected to the target company board of directors.17Hostile vs. Friendly mergersThe classification of a merger as friendly or hostile is from the perspective of the board of directors of the target company.A friendly merger is one in which the board negotiates and accepts an offer.A hostile merger is one in which the board of the target firm attempts to prevent the merger offer from being successful.

Copyright 2013 CFA Institute18LOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management.Pages 422423

Hostile vs. Friendly Mergers

The classification of a merger as friendly or hostile is from the perspective of the board of directors of the target company. A friendly merger is one in which the board negotiates and accepts an offer. A hostile merger is one in which the board of the target firm attempts to prevent the merger offer from being successful. Note: A hostile merger offer can become a friendly merger if the board of the target acquiesces.Example: In 2012, Martin Marietta Materials (MLM) made a bid for Vulcan Materials (VMC).

Discussion question: If you are a target firm shareholder and there is a bid for the stock that exceeds the target share price pre-bid, what action, if any, would you want the board of directors of the target firm to take?185. TakeoversTakeover defenses are intended to either prevent the transaction from taking place or to increase the offer.Pre-offer mechanisms are triggered by changes in control, generally making the target less attractive. Post-offer mechanisms tend to address ownership of shares and reduce the hostile acquirers power gained from its ownership interest in the target.

Copyright 2013 CFA Institute19LOS: Distinguish among pre-offer and post-offer takeover defense mechanisms.Pages 424429

5. Takeovers

Takeover defenses are intended to either prevent the transaction from taking place, or to increase the offer.Pre-offer mechanisms are triggered by changes in control, generally making the target less attractive. Post-offer mechanisms tend to address ownership of shares and reduce the hostile acquirers power gained from its ownership interest in the target.

19Takeover defensesPre-Offer Takeover Defense MechanismsPoison pills (flip-in pill and flip-over pill)Poison putsIncorporation in a state with restrictive takeover lawsStaggered board of directorsRestricted voting rightsSupermajority voting provisionsFair price amendmentsGolden parachutesPost-Offer Takeover Defense MechanismsJust say no defenseLitigationGreenmailShare repurchaseLeveraged recapitalizationCrown jewels defensesPac-Man defenseWhite knight defenseWhite squire defense

Copyright 2013 CFA Institute20LOS: Distinguish among pre-offer and post-offer takeover defense mechanisms.Pages 424428

Takeover Defenses

Pre-offer takeover defense mechanisms:Poison pills Any device that makes it more expensive for the acquirer to take control of the target without the target boards approvalTriggered by a change in control; can be rescinded if the offer becomes friendlyFlip-in pill: Target shareholders have the right to buy shares of the target at a discount.Flip-over pill: Target shareholders have the right to buy shares of the acquirer at a discount. Poison puts Allows the bondholders of the target to put the shares back to the target companyIntended to reduce the cash stores of the target companyIncorporation in a state with restrictive takeover laws (United States)Some states give target companies more power to fend off an unwanted takeover (e.g., Ohio and Pennsylvania).Staggered board of directors By having board terms staggered through time, it takes longer to get control through a proxy fight.Restricted voting rights Provision that prevents shareholders who have recently acquired large blocks of shares (objective: hostile acquirer) from votingSupermajority voting provisions Require a percentage of votes larger than simply a majority for change of control votesFair price amendments Specify the minimum price in an acquisitionMay be relative to trading values at a point or range in timeGolden parachutes Compensation agreement between the target firm and executives of the target firm in which these employees receive substantial payments if there is a change in control

Post-offer takeover defense mechanismsJust say no defense Board of directors rejects offer.If bear hug, the board would make the case for a higher bid.Litigation Lawsuit based on violation of securities laws or on anticompetitive grounds is filed.Greenmail The target repurchases shares from the party attempting to acquire the target.Share repurchase Perform a stock repurchase, which may raise the price of the stock.Could buy all shares in a leveraged buyoutLeveraged recapitalization Borrow heavily to finance a share repurchase, which makes the target more levered and, hence, unattractive.Crown jewels defenses Sell an asset, division, or subsidiary that is attractive to the acquiring company.Pac-Man defense Offer to buy acquirer.White knight defense Find a friendly third party to buy the target.White squire defense Find a friendly third party to buy a minority (yet substantial) interest in the target.

206. RegulationCopyright 2013 CFA Institute21Pages 429434

6. Regulation

Regulation of M&A takes two forms: antitrust laws and securities law.Antitrust pertains to the effect of the M&A activity on competition.Securities laws pertain to the M&A process and disclosures.21Antitrust Law: United StatesCopyright 2013 CFA Institute22Pages 430431

Antitrust Law: United StatesSherman Antitrust Act (1890)Made combinations, contracts, and conspiracies in restraint of trade or attempts to monopolize illegalClayton Antitrust Act (1914)Outlawed specific business practicesCellerKefauver Act (1950)Closed loopholes in the Clayton ActHartScottRodino Antitrust Improvements Act (1976)Gave the FTC and the Justice Department an opportunity to review and challenge mergers in advance

22AntitrustThe European Commission reviews combinations for antitrust issues.Regulatory bodies besides the FTC may review combinations (e.g., U.S. Federal Communications Commission, Federal Reserve Bank, state insurance commissions).If the combination involves companies in different countries, it may require approvals by all countries regulatory bodies.Copyright 2013 CFA Institute23Pages 430431

AntitrustThe European Commission reviews combinations for antitrust issues.Regulatory bodies besides the FTC may review combinations (e.g., U.S. Federal Communications Commission, Federal Reserve Bank, state insurance commissions).If the combination involves companies in different countries, it may require approvals by all countries regulatory bodies.

23The HHICopyright 2013 CFA Institute24HHI Concentration Level and Possible Government ActionPost-Merger HHIConcentrationChange in HHIGovernment ActionLess than 1,000Not concentratedAny amountNo actionBetween 1,000 and 1,800Moderately concentrated100 or morePossible challengeMore than 1,800Highly concentrated50 or moreChallenge24Example: HHIConsider an industry that has six companies. Their respective market shares are as follows:

What is the likely government action, if any, if Companies E and F combined?Copyright 2013 CFA Institute25CompanyMarket ShareA25%B15%C15%D15%E15%F15%100%LOS: Calculate the HerfindahlHirschman Index (HHI) and evaluate the likelihood of an antitrust challenge for a given business combination.Pages 431433

Example: HHI

Note: This example is similar, but not identical, to Example 10-7.

Consider an industry that has six companies and their respective market shares:

CompanyMarket share A 25% B 15% C 15% D 15% E 15% F 15% 100%

What is the likely government action, if any, if Companies E and F combined?

25Example: HHICompanyMarket ShareHHI BeforeCompanyMarket ShareHHI AfterA25%625A25%625B15%225B15%225C15%225C15%225D15%225D15%225E15%225E+F30%900F15%225Total100%1125Total100%1575Copyright 2013 CFA Institute26The industry would be considered moderately concentrated before and after the combination of E and F, and The change in the HHI is 450, which may result in a government challenge.LOS: Calculate the HerfindahlHirschman Index (HHI) and evaluate the likelihood of an antitrust challenge for a given business combination.Pages 431433

Example: HHI (continued)

For example: Company A: (25% x 100)2 = 625

Use the total HHI post-merger and the change in the total pre- to post-merger, and compare these results with Exhibit 10-2 (page 431).The industry would be considered moderately concentrated before and after the combination of E and F, and The change in the HHI is 450, which may result in a government challenge.

26Securities Laws: United StatesWilliams Act (1968): Requires public disclosure when a party acquires 5% or more of a targets common stock.Specifies rules and restrictions pertaining to a tender offer.

Copyright 2013 CFA Institute27Pages 433434

Securities Laws: United States

Williams Act (1968): Requires public disclosure when a party acquires 5% or more of a targets common stock.Specifies rules and restrictions pertaining to a tender offer.

277. Merger analysisThe discounted cash flow (DCF) method is often used in the valuation of the target company. The cash flow that is most appropriate is the free cash flow (FCF), which is the cash flow after capital expenditures necessary to maintain the company as an ongoing concern.The goal is to estimate future FCF.We can use pro forma financial statements to estimate FCFWe use a two-stage model when we can more accurately estimate growth in the near future and then assume a somewhat slower growth out into the future.

Copyright 2013 CFA Institute28LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each.Pages 434450

7. Merger Analysis

The discounted cash flow (DCF) method is often used in the valuation of the target company. The cash flow that is most appropriate is the free cash flow (FCF), which is the cash flow after capital expenditures necessary to maintain the company as an ongoing concern.The goal is to estimate future FCF.We can use pro forma financial statements to estimate FCF.We use a two-stage model when we can more accurately estimate growth in the near future and then assume a somewhat slower growth out into the future.

28Estimating Free Cash Flow (FCF)Copyright 2013 CFA Institute29LOS: Calculate free cash flows for a target company and estimate the companys intrinsic value based on discounted cash flow analysis.Pages 434438

Estimating Free Cash Flow

ProcessNet interest after tax = (Interest expense Interest income) (1 Tax rate)Unlevered net income = Net income + Net interest after taxNOPLAT = Unleveraged net income + Change in deferred taxes (NOPLAT is net operating profit less adjusted taxes)FCF = NOPLAT + Noncash charges Change in working capital Capital expenditures

29Example: FCF for the ABC CompanyNet income$40Interest expense$5Interest income$2Copyright 2013 CFA Institute30Change in deferred taxes$3Depreciation$10Change in working capital$6Capital expenditures$20From the pro forma income statementFrom the pro forma income statementAssumedTax rate =45%What is ABCs free cash flow?Suppose analysts have constructed pro forma financial statements for the ABC Company and report the following:LOS: Calculate free cash flows for a target company and estimate the companys intrinsic value based on discounted cash flow analysis.Pages 434438

Example: Calculating FCF

This example focuses on the calculation of a given years FCF so that we can demonstrate the FCF calculation.The information needed for this calculation comes from two pro forma sources: the income statement and the statement of cash flows. 30Example: FCFNet income$40.00PlusNet interest after tax1.65Equals Unlevered net income$41.65PlusChange in deferred taxes3.00EqualsNet operating profit minus adjusted taxes$44.65PlusDepreciation10.00MinusChange in working capital6.00MinusCapital expenditures20.00EqualsFree cash flow$28.65Copyright 2013 CFA Institute31LOS: Calculate free cash flows for a target company and estimate the companys intrinsic value based on discounted cash flow analysis.Pages 434438

Example: FCF

Net income$40.00PlusNet interest after tax 1.65Equals Unlevered net income$41.65PlusChange in deferred taxes 3.00EqualsNet operating profit less adjusted taxes$44.65PlusDepreciation 10.00MinusChange in working capital 6.00MinusCapital expenditures 20.00EqualsFree cash flow$28.65

31Discounted Cash Flow (DCF) and the Terminal ValueWe can estimate the terminal value:Assuming a constant growth after the initial few years orAssuming a multiple (based on comparables) of pro forma FCF for the last estimated year.

Copyright 2013 CFA Institute32LOS: Calculate free cash flows for a target company and estimate the companys intrinsic value based on discounted cash flow analysis.Pages 438439

DCF and the Terminal Value

We can estimate the terminal value: Assuming a constant growth after the initial few years orAssuming a multiple (based on comparables) of pro forma FCF for the last estimated year.

32The DCF methodAdvantages of using the DCF method:The model allows for changes in cash flows in the future. The cash flows and estimated value are based on forecasted fundamentals.The model can be adapted for different situations.Disadvantages of using the DCF method:For a rapidly growing company, the FCF and net income may be misaligned (e.g., higher-than-normal capital expenditure).Estimating future cash flows is difficult because of the uncertainty.Estimating discount rates is difficult, and these rates may change over time.The terminal value estimate is sensitive to the assumptions and model used.Copyright 2013 CFA Institute33LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each.Page 440

The DCF method

Advantages and disadvantagesAdvantages of using the DCF methodThe model allows for changes in cash flows in the future. The cash flows and estimated value are based on forecasted fundamentals.The model can be adapted for different situations.

Disadvantages of using the DCF methodFor a rapidly growing company, the FCF and net income may be misaligned (e.g., higher than normal capital expenditure).Estimating future cash flows is difficult because of the uncertainty.Estimating discount rates is difficult, and these rates may change over time.The terminal value estimate is sensitive to the assumptions and model used.

33Comparable Company AnalysisCopyright 2013 CFA Institute34LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each.Pages 440444

Comparable Company Analysis

Process: Select comparable companiesPublicly traded companies that are similar to the subject companySame or similar industryCalculate relative value measuresEnterprise value multiplesPrice multiplesApply metrics to target Judgment needed to select appropriate metricEstimate takeover priceTakeover premium added

34Example: Comparable Company AnalysisSuppose an analyst has gathered the following information on the target company, the XYZ Company:

If the typical takeover premium is 20%, what is the XYZ Companys value in a merger using the comparable company approach?

Copyright 2013 CFA Institute35XYZ CompanyAverage of ComparablesEarnings$10 millionP/E of comparables30 timesCash flow$12 millionP/CF of comparables25 timesBook value of equity$50 millionP/BV of comparables2 timesSales$100 millionP/S of comparables2.5 timesLOS: Estimate the value of a target company using comparable company and comparable transaction analyses.Pages 440444

Example: Comparable Company Analysis

Suppose an analyst has gathered the following information on the target company, the XYZ Company:

XYZ CompanyAverage of comparablesEarnings$10 millionP/E of comparables30 timesCash flow$12 millionP/CF of comparables25 timesBook value of equity$50 millionP/BV of comparables2 timesSales$100 millionP/S of comparables2.5 times

If the typical takeover premium is 20%, what is the XYZ Companys value in a merger using the comparable company approach?

Note: This example does not require calculating the mean of the comparables and makes the assumption, as does Example 10-8, that the arithmetic average of the comparables multiple and resultant values is the most appropriate.

Discussion question: If there is a wide dispersion among the multiples of the comparables, is an arithmetic mean of these multiples most appropriate?35Example: Comparable Company AnalysisAssuming that the average of the values from the different multiples is most appropriate:

Copyright 2013 CFA Institute36Comparables MultiplesEstimated Stock ValueEarnings$10 million30$300 millionCash flow$12 million25$300 millionBook value of equity$50 million2$100 millionSales$100 million2.5$250 millionAverage = $237.5 millionEstimated takeover price of the XYZ Company = $237.5 million 1.2 = $285 millionLOS: Estimate the value of a target company using comparable company and comparable transaction analyses.Pages 440444

Example: Comparable Company Analysis

Assuming that the average of the values from the different multiples is most appropriate:

Using comparables multiplesEstimated stock valueEarnings $10 million 30$300 millionCash flow$12 million 25$300 millionBook value of equity$50 million 2$100 millionSales$100 million 2.5$250 millionAverage = $237.5 million

Estimated takeover price of the XYZ Company = $237.5 million 1.2 = $285 million

Note: The multiplier of 1.2 is from the takeover premium: 1 + 0.20 = 1.236Comparable Company AnalysisAdvantagesProvides reasonable estimate of the target companys valueReadily available inputsEstimates based on markets value of company attributesDisadvantagesSensitive to market mispricingSensitive to estimate of the takeover premium, and historical premiums may not be accurate to apply to subsequent mergersDoes not consider specific changes that may be made in the target post-merger

Copyright 2013 CFA Institute37LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each.Pages 443444

Comparable Company Analysis

Advantages and disadvantagesAdvantagesProvides reasonable estimate of the target companys valueReadily available inputsEstimates based on markets value of company attributesDisadvantagesSensitive to market mispricingSensitive to estimate of the takeover premium, and historical premiums may not be accurate to apply to subsequent mergersDoes not consider specific changes that may be made in the target post-merger

37Comparable Transaction AnalysisCopyright 2013 CFA Institute38LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each.Pages 444445

Comparable Transaction Analysis

ProcessCollect information on recent takeover transactions of comparable companies.Calculate multiples for comparable companies (e.g., P/E, P/CF).Estimate takeover value based on multiples.

38Example: Comparable Transaction AnalysisMNO CompanyAverage of Multiples of Comparable TransactionsEarnings$10 millionP/E of comparables15 timesCash flow$12 millionP/CF of comparables20 timesBook value of equity$50 millionP/BV of comparables5 timesSales$100 millionP/S of comparables3 timesCopyright 2013 CFA Institute39Suppose an analyst has gathered the following information on the target company, the MNO Company:Estimate the value of the MNO Company using the comparable transaction analysis, giving the cash flow multiple 70% and the other methods 10% each. LOS: Estimate the value of a target company using comparable company and comparable transaction analyses.Pages 444445

Example: Comparable Transaction Analysis

Suppose an analyst has gathered the following information on the target company, the MNO Company:

MNO CompanyAverage of comparablesEarnings$10 millionP/E of comparables15 timesCash flow$12 millionP/CF of comparables20 timesBook value of equity$50 millionP/BV of comparables5 timesSales$100 millionP/S of comparables3 times

Estimate the value of the MNO Company using the comparable transaction analysis, giving the cash flow multiple 70% and the other methods 10% each.

Note: What is the difference between the comparable transaction analysis and the comparable company analysis? The company analysis uses comparables that are similar but that may or may not be involved in M&A. The comparable transaction analysis uses multiples only of recent transactions of comparable companies.39Example: Comparable Transaction AnalysisComparables Transaction MultiplesEstimated Stock ValueEarnings$10 million15$150 millionCash flow$12 million20$240 millionBook value of equity$50 million5$250 millionSales$100 million3$300 millionCopyright 2013 CFA Institute4040Comparable Transaction AnalysisAdvantagesDoes not require specific estimation of a takeover premiumBased on recent market transactions, so information is current and observedReduces litigation riskDisadvantagesDepends on takeover transactions being correct valuationsThere may not be sufficient transactions to observe the valuationsDoes not include value of changes to be made in target

Copyright 2013 CFA Institute41LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each.Page 446

Comparable Transaction Analysis

Advantages and disadvantagesAdvantagesDoes not require specific estimation of a takeover premiumBased on recent market transactions, so information is current and observedReduces litigation riskDisadvantagesDepends on takeover transactions to be correct valuationsThere may not be sufficient transactions to observe the valuationsDoes not include value of changes to be made in target

41Evaluating BidsCopyright 2013 CFA Institute42LOS: Evaluate a merger bid, calculate the estimated post-merger value of an acquirer, and calculate the gains accrued to the target shareholders versus the acquirer shareholders.Pages 446450

Evaluating Bids

The acquiring firm shareholders want to minimize the amount paid to target shareholders, not paying more than the pre-merger value of the target plus the value of the synergies.The target shareholders want to maximize the gain, accepting nothing below the pre-merger market value.

42Evaluating bids: FormulasTarget shareholders gain = Premium = PT VT(10-7)wherePT = price paid for the target companyVT = pre-merger value of the target company

Acquirers gain = Synergies Premium = S (PT VT)(10-8)whereS = synergies created by the business combination

VA* = VA + VT + S C(10-9)whereVA* = post-merger value of the combined companiesVA = pre-merger value of the acquirerC = cash paid to target shareholders

Copyright 2013 CFA Institute43LOS: Evaluate a merger bid, calculate the estimated post-merger value of an acquirer, and calculate the gains accrued to the target shareholders versus the acquirer shareholders.Pages 446447

Evaluating Bids: Formulas

Key: Estimating the value added from synergy43Example: Evaluating BidsSuppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid was made public was $15 per share. Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%. What are the synergistic gains from this merger?What parties, if any, share in these gains? What is the estimated value of the Big Company post-merger?

Copyright 2013 CFA Institute44LOS: Evaluate a merger bid, calculate the estimated post-merger value of an acquirer, and calculate the gains accrued to the target shareholders versus the acquirer shareholders.Pages 446450

Example: Evaluating Bids

Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid was made public was $15 per share. Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%. What are the synergistic gains from this merger?What parties, if any, share in these gains? What is the estimated value of the Big Company post-merger?

44Example: Evaluating Bids Synergistic gains = $2 million 0.10 = $20 millionDivision of gains: First calculate the gains for each party and then evaluate the division.Target shareholders gain = $18 million $15 million = $3 millionAcquirers gain = $20 million 3 million = $17 millionLittle shareholders get $3 million $20 million = 15% of the gainBig shareholders get $17 million $20 million = 85% of the gain

Value of Big Company post-merger = $400 million + $15 million + $20 million $18 million = $417 million

Copyright 2013 CFA Institute45LOS: Evaluate a merger bid, calculate the estimated post-merger value of an acquirer, and calculate the gains accrued to the target shareholders versus the acquirer shareholders.Pages 446450

Example: Evaluating Bids

Synergistic gains = $2 million 0.10 = $20 million (valued as a perpetuity)

Division of gains: First calculate the gains for each party and then evaluate the division.Target shareholders gain = $18 million $15 million= $3 millionAcquirers gain = $20 million 3 million = $17 millionLittle shareholders get $3 million $20 million = 15% of the gainBig shareholders get $17 million $20 million = 85% of the gain

Value of Big Company post-merger = $400 million + $15 million + $20 million $18 million = $417 million

45Effects of Price and Payment MethodThe more confidence in the realization of synergies,the greater the chance that the acquiring firm will pay cash andthe more the target company shareholders will prefer stock.The greater the use of stock in a deal, the greater the burden of the risks borne by the target shareholders andthe greater the potential benefits accrue to the target shareholders.The greater the confidence of the acquiring firm managers in estimating the value of the target, the more likely the acquiring firm is to offer cash.Copyright 2013 CFA Institute46LOS: Explain the effects of price and payment method on the distribution of risks and benefits in a merger transactionPage 450

Effects of Price and Payment Method

The more confidence in the realization of synergies, the greater the chance that the acquiring firm will pay cash andthe more that the target company shareholders will prefer stock.

The greater the use of stock in a deal, the greater the burden of the risks borne by the target shareholders andthe greater the potential benefits accrue to the target shareholders.

The greater the confidence of the acquiring firm managers in estimating the value of the target, the more likely the acquiring firm is to offer cash.

ExamplesCash offersInBevs acquisition of the remaining 50% interest in Grupo Modelo (2012)Stock offersOffice Depot and Office Max (2013, in process)Stock and cash offersKrafts acquisition of Cadbury (2010)ICE acquisition of NYSE Euronext (2012)

468. Who benefits from Mergers?Mergers create value for the target company shareholders in the short run.Acquirers tend to overpay in merger bids.The transfer of wealth is from acquirer to target company shareholders.Roll: Overpayment results from hubris.Acquirers tend to underperform in the long run.They are unable to fully capture any synergies or other benefit from the merger.Copyright 2013 CFA Institute47LOS: Describe empirical evidence related to the distribution of benefits in a merger.Pages 450451

8. Who Benefits from Mergers?

Mergers create value for the target company shareholders in the short run.

Acquirers tend to overpay in merger bids. The transfer of wealth is from acquirer to target company shareholders.Roll: Overpayment results from hubris.Note: Winners curse

Acquirers tend to underperform in the long run.They are unable to fully capture any synergies or other benefit from the merger.

47Mergers that create valueBuyer is strong.Transaction premiums are relatively low.Number of bidders is low.Initial market reaction to the news is favorable.Copyright 2013 CFA Institute48LOS: Describe empirical evidence related to the distribution of benefits in a merger.Page 451

Mergers that Create Value

Buyer is strong.Transaction premiums are relatively low.Number of bidders is low.Initial market reaction to the news is favorable.

489. Corporate restructuringA divestiture is the sale, liquidation, or spin-off of a division or subsidiary.

Copyright 2013 CFA Institute49LOS: Distinguish among divestitures, equity carve-outs, spin-offs, split-offs, and liquidation.Pages 451452

9. Corporate Restructuring

49Reasons for RestructuringCompanies generally increase in size with a merger or acquisition.Restructuring, which includes divestitures, generally follows periods of merger and acquisitions.Reasons for restructuring:Change in strategic focusPoor fitReverse synergyFinancial or cash flow needsCopyright 2013 CFA Institute50LOS: Explain major reasons for divestitures.Page 452

Reasons for Restructuring

Companies generally increase in size with a merger or acquisition.Restructuring, which includes divestitures, generally follows periods of merger and acquisitions.Reasons for restructuring:Change in strategic focusPoor fitReverse synergyFinancial or cash flow needs

50Forms of divestitureSale to another company:Direct sale of assets Creation of a separate entity and the sale of interests in that entity (i.e., an equity carve-out) Spin-off: Parent companys shareholders receive shares of stock Split-offs are similar to a spin-off, but only some shareholders receive shares in the new entity in exchange for shares in the parent companys stock.Liquidation: Breaking up the entity and selling off its assets piecemealCopyright 2013 CFA Institute51LOS: Distinguish among divestitures, equity carve-outs, spin-offs, split-offs, and liquidation.Page 452

Forms of Divestiture

Sale to another company:Direct sale of assets Example of sale of assets: November 2012 of McGraw-Hills education unit to Apollo Global ManagementCreation of a separate entity and the sale of interests in that entity (i.e., an equity carve-out) Example of an equity carve out: August 2012 carve-out of E. I. DuPont de Nemours and Co. (ticker: DD) auto paint business by Carlyle Group (ticker: CG)

Spin-off: Parent companys shareholders receive shares of stock in the spun-off companyExample of a spin-off: April 2012 spin-off of Phillips 66 (ticker: PSX) from ConocoPhillips (ticker: COP)Example of a spin-off: December 2011 spin-off of TripAdvisor (ticker: TRIP) from Expedia (ticker: EXPE)Split-offs are similar to a spin-off, but only some shareholders receive shares in the new entity in exchange for shares in the parent companys stock.Another name of a spin-off: Hive-off or hived-offVariation: Split-up, in which shareholders get stock in two companies in exchange for stock in parentExamples: McGraw Hill (2012), Marathon Oil (2012)

Liquidation: Breaking up the entity and selling off its assets piecemeal

5110. SummaryAn acquisition is the purchase of some portion of one company by another, whereas a merger represents the absorption of one company by another.Mergers may be a statutory merger, a subsidiary merger, or a consolidation.Horizontal mergers occur among peer companies engaged in the same kind of business, vertical mergers occur among companies along a given value chain, and conglomerates are formed by companies in unrelated businesses.Merger activity has historically occurred in waves.Waves have typically coincided with a strong economy and buoyant stock market activity. Merger activity tends to be concentrated in a few industries, usually those undergoing changes.There are number of motives for a merger or acquisition; some are justified, some are dubious.

Copyright 2013 CFA Institute5210. Summary52Summary (continued)A merger transaction may take the form of a stock purchase or an asset purchase. The decision of which approach to take will affect other aspects of the transaction.The method of payment for a merger may be cash, securities, or a mixed offering with some of both. Hostile transactions are those opposed by target managers, whereas friendly transactions are endorsed by the target companys managers. There are a variety of both pre- and post-offer defenses a target can use to ward off an unwanted takeover bid.Copyright 2013 CFA Institute5310. Summary53Summary (continued)Pre-offer defense mechanisms include poison pills and puts, incorporation in a jurisdiction with restrictive takeover laws, staggered boards of directors, restricted voting rights, supermajority voting provisions, fair price amendments, and golden parachutes.Post-offer defenses include just say no defense, litigation, greenmail, share repurchases, leveraged recapitalization, crown jewel defense, Pac-Man defense, or finding a white knight or a white squire.Antitrust legislation prohibits mergers and acquisitions that impede competition.The Federal Trade Commission and Department of Justice review mergers for antitrust concerns in the United States. The European Commission reviews transactions in the European Union.The HerfindahlHirschman Index (HHI) is a measure of market power based on the sum of the squared market shares for each company in an industry.The Williams Act is the cornerstone of securities legislation for M&A activities in the United States.

Copyright 2013 CFA Institute5410. Summary 54Summary (continued)Three major tools for valuing a target company are discounted cash flow analysis, comparable company analysis, and comparable transaction analysis.In a merger bid, the gain to target shareholders is the takeover premium. The acquirer gain is the value of any synergies created by the merger, minus the premium paid to target shareholders. The empirical evidence suggests that merger transactions create value for target company shareholders, yet acquirers tend to accrue value in the years following a merger. A divestiture is a transaction in which a company sells, liquidates, or spins off a division or a subsidiary.A company may divest assets using a sale to another company, a spin-off to shareholders, or a liquidation.Copyright 2013 CFA Institute5510. Summary55