Chapter 22
Mergers and Corporate Control
ANSWERS TO END-OF-CHAPTER QUESTIONS
22-1 a. Synergy occurs when the whole is greater than the sum of its parts. When applied to mergers, a synergistic merger occurs when the postmerger free cash flows exceed the sum of the separate companies' premerger free cash flows. A merger is the joining of two firms to form a single firm.
b. A horizontal merger is a merger between two companies in the same line of business. In a vertical merger, a company acquires another firm that is "upstream" or "downstream"; for example, an automobile manufacturer acquires a steel producer. A congeneric merger involves firms that are interrelated, but not identical, lines of business. One example is Prudential's acquisition of Bache & Company. In a conglomerate merger, unrelated enterprises combine, such as Mobil Oil and Montgomery Ward.
c. A friendly merger occurs when the target company's management agrees to the merger and recommends that shareholders approve the deal. In a hostile merger, the management of the target company resists the offer. A defensive merger occurs when one company acquires another to help ward off a hostile merger attempt. A tender offer is the offer of one firm to buy the stock of another by going directly to the stockholders, frequently over the opposition of the target company’s management. A target company is a firm that another company seeks to acquire. Breakup value is a firm’s value if its assets are sold off in pieces. An acquiring company is a company that seeks to acquire another firm.
d. An operating merger occurs when the operations of two companies are integrated with the expectation of obtaining synergistic gains. These may occur due to economies of scale, management efficiency, or a host of other reasons. In a pure financial merger, the companies will not be operated as a single unit, and no operating economies are expected.
e. The free cash flow to equity model, or also called the residual dividend model, first calculates FCFE, which is the free cash flow payable to shareholders. FCFE is free cash flow less interest expense plus the interest tax shield. It then discounts the FCFEs at the levered cost of equity to arrive at the value of equity in operations. You add in the value of non-operating assets and you get the value of the equity. To get the value of operations you then add in the value of the debt.
f. Under purchase accounting, the acquiring firm is assumed to have “bought” the acquired company in much the same way it would buy any capital asset. Any excess of the purchase price over the book value of assets is added to goodwill, which may be expensed for Federal income tax purposes, but may not be expensed for shareholder reporting.
g. A white knight is a friendly competing bidder that a target management likes better than the company making a hostile offer, and the target solicits a merger with the white knight as a preferable alternative. A proxy fight is an attempt to gain control of a firm by soliciting stockholders to vote for a new management team.
h. A joint venture involves the joining together of parts of companies to accomplish specific, limited objectives. Joint ventures are controlled by the combined management of the two (or more) parent companies. A corporate or strategic alliance is a cooperative deal that stops short of a merger.
i. A divestiture is the opposite of an acquisition. That is, a company sells a portion of its assets, often a whole division, to another firm or individual. In a spin-off, a holding company distributes the stock of one of the operating companies to its shareholders. Thus, control passes from the holding company to the shareholders directly.
j. A holding company is a corporation formed for the sole purpose of owning stocks in other companies. A holding company differs from a stock mutual fund in that holding companies own sufficient stock in their operating companies to exercise effective working control. An operating company is a company controlled by a holding company. A parent company is another name for a holding company. A parent company will often have control over many subsidiaries.
k. Arbitrage is the simultaneous buying and selling of the same commodity or security in two different markets at different prices, and pocketing a risk-free return. In the context of mergers, risk arbitrage refers to the practice of purchasing stock in companies that may become takeover targets.
22-2 Horizontal and vertical mergers are most likely to result in governmental intervention, but mergers of this type are also most likely to result in operating synergy. Conglomerate and congeneric mergers are attacked by the government less often, but they also are less likely to provide any synergistic benefits.
22-3 A tender offer might be used. Although many tender offers are made by surprise and over the opposition of the target firm's management, tender offers can and often are made on a "friendly" basis. In this case, management (the board of directors) of the target company endorses the tender offer and recommends that shareholders tender their shares.
22-4 An operating merger involves integrating the company's operations in hopes of obtaining synergistic benefits, while a pure financial merger generally does not involve integrating the merged company's operations.
22-5 The three models—APV, FCFE and corporate valuation (CV) all do the same thing. They value a firm’s operations and its equity. When implemented under a scenario that is consistent with the assumptions of all three models, they will all give the same answer. The CV model discounts free cash flows at the WACC to obtain the value of operations. You then add non-operating assets and subtract out debt to arrive at the value of equity. In this case the value of the interest tax shield is incorporated because the WACC is used to discount the cash flows; the WACC has a reduction in the cost of debt to account for its tax shield. The APV model treats the free cash flows and the interest tax shields separately, discounting both of them at the unlevered cost of equity. The result is the value of operations. You add in the value of non-operating assets to get the value of the firm, and subtract out the value of the debt to get the value of the equity. The FCFE model calculates free cash flows to equity as FCF – interest expense + interest tax shield. The model then discounts these FCFEs at the levered cost of equity to get the value of equity in operations. You add in the value of non-operating assets to get the value of equity, and then add in the value of the debt to get the value of the entire firm.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
22-1 FCF1 = 2.00(1.05) = $2.1 million; g = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd = 30%; T = 40%; rd = 8% Vops = ? P0 = ?
rsL = rRF + RPM(b)
= 5% + 6%(1.4)
= 13.4%.
WACC = wdrd(1-T) + wsrs
= 0.30(8%)(0.60) + 0.70(13.4%)
= 10.82%
Vops =
=
= $36.08 million
VS = Vops – debt
= 36.08 – 10.82 = $25.26 million
Price = 25.26 million / 1 million shares
= $25.26 / share.
22-2 FCF1 = $2.5 million, FCF2 = $2.9 million, FCF3 = $3.4 million, and FCF4 = 3.57 million; Interest in the 4th year = $1.472 million. g = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd = 30%; T = 40%; rd = 8% Vops = ? P0 = ?
rsU = wdrd + wsrsL Note: rsL was calculated in problem 1 to be 13.4%
= 0.30(8%) + 0.70(13.4%)
= 11.78%
WACC was calculated in problem 1 to be 10.82%. Since the horizon capital structure is the same as in problem 1, the WACC is the same, although we don’t need WACC to apply the APV.
Tax shields are TS1 = TS2 = TS3 = Interest x T = $1,500,000(0.40) = $600,000, and TS4 = $1,472,000 (0.40) = $588,800.
Tax shield horizon value = TS4(1+g)/(rsU-g)
= 0.5888 (1.05)/(0.1178-0.05)
= 9.12
Value of tax shields =
= $7.67 million.
Unlevered horizon value = FCF4(1+g)/(rsU-g)
= 3.57(1.05)/(0.1178-0.05)
= 55.29
Unlevered Vops =
= $44.69
Value of operations = unlevered Vops + value of tax shields
= 44.69 + 7.67
= 52.36 million
Equity value to Harrison = Vops – Debt
= 52.36 million - 10.82 million
= 41.54 million
or $41.54 per share since there are 1 million shares outstanding.
Note: Since the capital structure isn’t changing and the company has reached its target capital structure by the horizon, you could have just used the corporate valuation model to calculate the value of operations. In the corporate valuation model you discount the FCFs at the WACC to get the value of operations:
Corporate Valuation Model Horizon Value = FCF4(1+g)/(WACC-g)
= 3.57(1.05)/(0.1082 – 0.05)
= 3.7485/(0.0582)
= $64.41 million
Value of operations =
= $52.19 million
which is the same as the value of operations calculated above, except for rounding differences (the answer above was $52.36 million).
22-3 On the basis of the answers in Problems 1 and 2, the bid for each share should range between $25.26 and $41.54.
22-4 The difference between this problem and Problem 2 is the tax shield in year 4, which reflects the 45% debt capital structure. TS4 = (new debt level)(interest rate on debt)(tax rate) = 30.6(0.085)(0.40) = $1.04 million. rsU = 11.78% was calculated in the earlier problems.
The tax shield horizon value is
= HVTS4 = TS5/(rsU – g) = TS4(1+g)/(rsU-g)
= 1.04(1.05)/(0.1178-0.05) = $16.11 million
Value of tax shields =
= $12.43 million
The unlevered horizon value and the unlevered value of operations is the same as in Problem 3:
Unlevered horizon value = FCF4(1+g)/(rsU-g)
= 3.57(1.05)/(0.1178-0.05)
= $55.29 million
Unlevered Vops =
= $44.69
The new value of operations is
Value of operations = unlevered Vops + value of tax shields
= 44.69 + 12.43
= 57.12 million
Equity value to Hastings = Vops – Debt
= 57.12 million - 10.82 million
= $46.30 million
or $46.30 per share since there are 1 million shares outstanding.
Although not necessary for the problem, you could calculate the new WACC that will prevail after the 45% target capital structure is reached.
rsL = rsU + (rsU –rd)(D/S)
= 11.78% + (11.78% - 8.5%)(0.45/0.55)
= 14.46%
WACC = wdrd(1-T) + wsrs
= 0.45(8.5%)(1-0.40) + 0.55(14.46%)
= 10.25%
22-5 a. The appropriate discount rate reflects the risk of the cash flows. Thus, it is Conroy’s unlevered cost of equity that should be used to discount the free cash flows and tax shields in years 1-5 and at the horizon. The horizon value should be calculated using Conroy’s tax shields at the stable target capital structure, which are provided for Year 5. Since Conroy’s beta = 1.3, its current cost of equity, rsL = 6% + 1.3(4.5%) = 11.85%. Since its percentage of debt is 25% and the rate on its debt is 9%, its unlevered cost of equity is
rsU = wdrd + wsrsL
= 0.25(9%) + 0.75 (11.85%)
= 11.14%
Interest5 = Debt4 (9.5%) = $22.27 (9.5%) = 2.116
TS5 = Interest5(Tax rate) = 2.116(0.35%) = 0.7405 (You must use the post merger tax rate)
In the other years, the tax shield is equal to the interest expense multiplied by the tax rate:
TS1 = 1.2(0.35) = 0.42, TS2 = 0.595, TS3 = 0.98, TS4 = 0.735
HVTS5 = TS6/(rsU – g) = TS5(1 + g)/(rsU – g)
= 0.7405(1.06)/(0.1114 – 0.06) = $15.28 million
The value of the tax shields = = $11.50 million
The unlevered horizon value is HVUL5 = FCF5(1+g)/(rsU – g)
= 2.12(1.06)/(0.1115-0.06)
= $43.74 million
The unlevered value of operations is
= $32.02 million
b. The value of operations is the sum of the interest tax shields and the unlevered value = 11.50 + 32.02 = $43.52 million.
The value of the equity is the value of operations (plus any non-operating assets, which are zero in this case) less debt:
Equity = 43.52 – 10.00 = $33.52 million. This is the maximum amount that Marston should pay for Conroy.
Although not required for the value calculation, the WACC at the new capital structure can be calculated. At the new capital structure of 40 percent debt with a rate of 9.5 percent, the new levered cost of equity and WACC will be:
rsL = rsU + (rsU –rd)(D/S)
= 11.14% + (11.14% - 9.5%)(0.40/0.60)
= 12.23%
WACC = wdrd(1-T) + wsrs
= 0.40(9.5%)(1-0.35) + 0.60(12.23%)
= 9.81%
22-6 a. BCC’s unlevered cost of equity depends on its pre-merger cost of equity and its pre-merger capital structure:
rsL = rRF + (RPM)b = 6% + (4%)1.40 = 11.6%.
rsU = wdrd + wsrsL = 0.40(10%) + 0.60(11.6%) = 10.96%
b. The free cash flows are NOPAT – investment in net operating capital = (Sales – CGS – selling expenses)(1-T) – investment in net operating capital. CGS is 65% of sales:
2013 / 2014 / 2015 / 2016 / 2017 / 2018Net sales / $450.00 / $518.00 / $555.00 / $600.00 / $643.00
Cost of Goods Sold / $292.50 / $336.70 / $360.75 / $390.00 / $417.95
SGA / $45.00 / $53.00 / $60.00 / $68.00 / $73.00
EBIT / $112.50 / $128.30 / $134.25 / $142.00 / $152.05
Taxes on EBIT (35%) / $39.38 / $44.90 / $46.99 / $49.70 / $53.22
NOPAT / $73.12 / $83.40 / $87.26 / $92.30 / $98.83
Total Operating Cap. / $800 / $850.00 / $930.00 / $1,005 / $1,075 / $1,150
Inv. in Op. Capital / $50.00 / $80.00 / $75.00 / $70.00 / $75.00
FCF / $23.12 / $3.40 / $12.26 / $22.30 / $23.83
TSn = Interestn(Tax rate)