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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 firms
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 companys
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 merger
2. Estimating the appropriate discount rate
3. 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

CF6
rg

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
Debt Ratio
Equity

Pre-Acq.
30 %
50%

Post-Acq.
0.8
1.0

Tax Rate = 40%


Rf = 7%
Rp = 8%
g = 5% from 2006
Year-end cashflows are:
Sales
COGS
Depreciation
EBIT
Interest
EBT
Taxes
Net Income
+ Depreciation
- Capex
Net Cash Flow

2003
$20m
10
2
8
3
5
2
3
2
4
$1.0.m

2004
$24m
12
2
10
3
7
2.8
4.2
2
4
$2.2m

2005
$28m
14
3
11
4
7
2.8
4.2
3
5
$2.2m

2006
$30m
15
3
12
4
8
3.2
4.8
3
5
$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

CFn
2.8 1.05

= $29.4
rg
0.15 0.05

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

$1.0
$2.2
$2.2 $2.8 $29.4

= $22.4m
1
2
1.15 1.15
1.153
1.154

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 industry
2. Selecting an appropriate multiple, e.g. P/E, Price-to-book, price-to-sales, price-to-EBITDA, etc,
based on comparable firms
3. Multiplying the target firms 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 firms earnings pre-merger are not necessarily a clear guide. Synergy
effects are estimated and added to the targets 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 firms 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 dont 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 companys 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 targets 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

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