Chapter 19

Analysis of takeovers
Solutions to questions

1 (a) The market in which alternative teams of managers compete for the right to control
corporate assets
(b) Combined or cooperative action that results in a combined company having a value
greater than the sum of the values of the two companies operating independently
(c) A takeover motivated by the opportunity to add value by replacing the managers of a
target company
(d) Temporary increases in the level of takeover activity
(e) Reducing the risk of default on debt by combining two companies, and thereby
providing additional resources to support obligations to lenders
(f) Cash flow in excess of that needed to implement all available positive NPV projects
(g) Increasing a companys earnings per share by acquiring a company with a lower PE
ratio
(h) An off-market bid as described in section 632 of the Corporations Act. The bidder
must provide a bidders statement to ASIC and to the target companys shareholders.
(i) A takeover offer under which the bidder offers to purchase the target companys
shares through transactions on the stock exchange
(j) A partial takeover offer in which the bidder offers to purchase a specified proportion
of each holders shares
(k) A bidder that is friendly to the management of a target company and typically makes a
late entry to a bidding contest for the target
(l) A contract under which the managers of a company receive large termination
payments if they are displaced by a change of control
(m) A reverse merger transaction in which a former subsidiary or division is separated
from a company as a separate listed entity
(n) A transaction in which a small group of investors uses a high proportion of borrowed
funds to acquire a company or a division of a business
(o) Overwhelming confidence and pride that is considered to affect the managers of some
acquiring companies, leading to payment of excessive prices for the shares of target
companies
(p) An aggressive acquirer who aims to profit by purchasing undervalued targets and
redeploying their assets to higher valued uses

2. One possibility is that Drakes managers are over-optimistic in arriving at the valuation of
$800 million. Assuming that the valuation is realistic, possible reasons for the increase in
value associated with the break-up of Duck include:
(a) Some or all of Ducks divisions are more valuable to other parties because of
economies of scale, or other operating synergies.

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 (b) Duck is poorly managed, perhaps because its top-level managers lack the skills
needed to manage a range of diverse divisions that operate in different industries.
(c) Duck is relatively inefficient because its conglomerate structure, with many levels of
management, results in slow decision making and high overhead costs.
(d) Ducks profitability and value have been reduced because cash generated by
profitable divisions is sometimes used to fund unprofitable projects and activities in
other divisions. That is, resource allocation decisions in Ducks conglomerate
structure may be poor, but can be improved by separating it into independent entities,
allowing performance to be measured more easily and giving investors greater
influence over resource allocation decisions.

3. The statement is false because a takeover is only one of the ways in which these outcomes
can be achieved. For example, synergies can also be exploited by joint ventures in which
complementary assets are combined. The threat of possible takeover can be important in
motivating managers to act in the interests of shareholders, but there are other important
mechanisms, such as including share ownership plans and share options in management
compensation packages.

4. It is true that the level of takeover activity in Australia appears to vary considerably over
time, and to be associated with the level of share prices. Similar observations have been
made in the US, but there is no generally-accepted economic explanation for them. As
discussed in the chapter, buoyant share prices reflect an optimistic outlook for
investments, some of which will be external. As noted in Section 19.1.2 there is recent
evidence that changes in the level of takeover activity are associated with economic
shocks that affect particular industries, and are often followed by industry re-structuring.
Other factors such as changes in legislative controls and foreign investment regulations
may also be relevant.

5. The terms are defined in Section 19.1.3.

6. A company can reduce its total risk by a takeover, but the systematic risk of the combined
company will simply be an average of the systematic risks of the two individual
companies. In general, investors can diversify easily in their own portfolios by purchasing
the shares of companies that operate in different industries. Therefore, a takeover by a
company does not offer any risk-reduction benefits that were not previously available to
investors. However, there may be cases where diversification by a (typically private or
family-controlled) company is of value, because there are barriers that prevent its
shareholders diversifying directly.

7. A takeover of a company with accumulated losses can be valuable, provided that the
acquiring company can use the tax losses. The circumstances where this is the case are
outlined in Section 19.2.1.

However, it should be noted that for Australian-owned companies, the benefits associated
with reducing company tax by using accumulated tax losses (or by using other means) are
likely to be small under the imputation tax system.

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8. The arguments as presented are both unsound. First, diversification is, in general, not a
sound reason for takeovers. Fleetings shareholders could diversify in their own portfolios
by buying shares in Budget, or other more successful computer companies. Therefore,
there is no reason for them to pay a premium for the company to do so. On the other
hand, there is nothing wrong with diversification provided that the investment is profitable
in its own right. In this case, there is no evidence that Budget is at all attractive as an
investment. Second, takeover of Budget might be profitable if its problems were due to,
say, inefficient management that could be replaced. But in this case, its problems flow
from fundamental characteristics of the computer industry. There is no reason to believe
that injecting more funds will be beneficial, particularly if the funds are used to buy
additional second-hand computers.

9. (a) The approach treats the valuation as a normal capital budgeting problem and is
theoretically sound. To be consistent, net cash flows from operations, without
allowing for any financing costs, can be discounted at the weighted average cost of
capital, which should be estimated on the basis of the risk of Minnows assets. The
market value of debt in Minnows capital structure should then be deducted to arrive
at a value for its equity. Potential problems relate mainly to the fact that the valuation
consists of two components:
(i) the value of Minnow as an independent entity
(ii) the value of benefits expected from combining the two companies.
Since (i) will generally be much larger than (ii), a small error in forecasting the post-
takeover cash flows of Minnow may lead Whale to believe that the takeover is viable,
when in fact it is not.
(b) This approach is also theoretically sound, since the value of a share can be regarded
as the present value of a perpetual stream of dividends. In this case, the discount rate
that should be used is the cost of equity capital. The main problems are analogous to
those of (a), since the expected dividends will again include the increase in dividends
expected from combining the two companies.
(c) Again, this is a theoretically sound way of obtaining an estimate of the maximum
price that Whale should be prepared to pay. Major advantages over (a) and (b) are
that focusing on incremental cash flows:
(i) means that the valuation is less prone to the effects of forecast errors
(ii) forces management to focus on the question: why should these two companies
be worth more when combined than when separate? Unless there are sound
reasons why this should be the case, the takeover would not be economically
viable.
A disadvantage of this procedure is that the market value of Minnow may already reflect
expectations of a possible takeover bid, in which case Whales valuation will be biased
upwards. However, it may be possible to estimate the magnitude of any such bias by
examining recent share price movements. It may be concluded, therefore, that it would be
preferable for Whale to use method (c) because of the above advantages over the other
two approaches.

10. (a) The share market will be valuing a company as an independent entity (unless it has
been identified as a possible target). The value of any company to a potential acquirer
may be quite different from its value as an independent entity because there may be
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 economic advantages from combining the two companies (for example, economies of
scale, improved management and tax advantages). If the difference between these
two values is positive and large, then the probability of a takeover bid will be high.
The value of the target to the acquiring company is the maximum price that the
acquirer could afford to pay. Its offer will be generally lower, so that not all of the
expected gains accrue to target shareholders.
(b) Asset backing based on book values relates to prices at which assets were acquired in
the past, and the statement of financial position does not purport to show what a
company is worth. The value of any asset is the higher of its value in use and its
salvage value, neither of which can be obtained from accounting records (unless all
assets and liabilities have been revalued recently to bring their book values into line
with market values). Also, intangible assets may be very important for some
companies, but in many cases, such assets will not be found in the accounts unless
they have been purchased.

11. (a) More efficient management. Valid where the existing management of the target is
inefficient or lacks the necessary skills, provided that the new team is in fact more
efficient.
Tax benefits. More effective utilisation of tax losses is possible, but such losses are
unlikely to be present given that Elephant is one of the largest companies in Australia.
Division into separate entities. Diversification in reverse. Diversification of itself is a
neutral factor (does not create or destroy value). Therefore, doing the reverse should
not affect overall value unless the break-up results in lower operating costs/better
efficiency, or it creates some unique investment opportunity for which investors are
prepared to pay a premium.
(b) Carrion is free to purchase further shares up to the 20 per cent threshold. To proceed
further, the alternatives are as follows:
(i) an off-market bid
(ii) a market bid
(iii) a creeping takeover.
Section 50 of the Trade Practices Act 1974 may also be relevant.
(c) $11.50 is the maximum Carrion should be prepared to pay. The lower the price, the
better its return, but Carrion will almost certainly have to offer a premium over $7.90.

12. The statement is false. A fundamental difference is that for a cash bid, the net cost is fixed,
in the sense that it depends only on the amount of the cash consideration and on the value
of the target as an independent entity. For a share exchange bid, the net cost depends on
the gain associated with the takeover and on the distribution of the gain between the two
companies shareholders. This means that the net cost depends on the price of the
acquiring companys shares after the bid has been announced. Other factors that may be
important include:
(a) the availability of cash;
(b) the fact that an issue of shares dilutes the ownership and control of existing
shareholders. Also, it may result in placing a strategic parcel of shares with parties
whose loyalty to the acquiring companys management is not assured; and
(c) the effect on the companys capital structure. For example, loan covenants or trust
deed provisions may restrict the raising of cash by borrowing.
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13. The benefit of an unregulated market for takeovers is that it provides a competitive
market for corporate control. The threat of takeovers in such a market encourages
efficiency, as managers of other companies have an incentive to identify inefficiently-
managed companies. Those who support regulation usually do so on equity grounds. They
suggest that the disadvantages of an unregulated environment include:
(a) the opportunity for those with skill in identifying inefficient companies to benefit at
the cost of the companies current shareholders; and
(b) the possibility of post-takeover minority shareholders suffering as a result of actions
taken by the acquiring company.

Australian legislation makes takeovers more expensive for the acquiring company.
Therefore, a takeover is likely to result in efficiency losses. It is a value judgment as to
whether this is justified, even when account is taken of equity considerations.

14. The makeup and the role of the Takeovers Panel is quite different to that of the Australian
Securities and Investments Commission (ASIC). Firstly, the Panels website
(www.takeovers.gov.au) describes it as a peer review body, with part-time members
appointed from the active members of Australias takeovers and business communities.
Further, section 659AA of the Corporations Act provides that the Takeovers Panel is the
primary dispute resolution authority during the life of a takeover bid. Importantly, in
addition to having the power to make a declaration of unacceptable circumstances with
respect to takeover activity, the Panel has the power to review certain exemptions or
modifications granted by ASIC to parties to a takeover. It is reasonable to suggest that the
ability of parties to a takeover to appeal decisions made by ASIC would be hampered if a
specialist body such as the Panel did not exist.

15. The Australian Competition and Consumer Commission (ACCC) draws its power with
respect to acquisition activity from section 50 of the Trade Practices Act 1974, which
prohibits acquisitions that would result in a substantial lessening of competition. It is
arguable from an economic viewpoint that such a prohibition may hinder the efficient
allocation of resources by allowing firms that are underutilising (or wasting) resources to
continue to operate, rather than be acquired by firms that are better able to utilise the
assets in place. Conversely, if an acquisition does result in a substantial lessening in
competition, then it is arguable that the acquirer has fewer incentives to operate efficiently,
given that it already has substantial market power that is undiminished by the threat of
competition. Examples of where the ACCC has exercised its power can be found by
perusing the media releases listed on the Commissions website at www.accc.gov.au.

16. The main factor is that a formal, or off-market, bid is much more flexible than a market
offer. For example:
Conditions can be attached to an off-market bid, whereas a market offer must be
unconditional.
The consideration for an off-market bid can be shares, cash or a combination of
shares and cash, whereas shares purchased under a market offer must be paid for with
cash.
Another difference is that if the price is increased, then, in the case of an off-market bid,
the higher price must be paid to all shareholders who accept the offer, including any who

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 previously accepted a lesser price. In the case of a market offer, the price can be increased
without having to pay the higher price to target shareholders who sold prior to the
increase. Because of this difference, target shareholders may delay their acceptance of a
market bid until the last few days of the offer period.

17. This statement is not true in that in some cases management might recommend rejection
of a takeover bid that is in the best interests of shareholders as a result of them acting in
their own best interests in terms of the tenure of their position as well as the compensation
that they are able to extract for themselves from the firm. This problem is commonly
referred to as managerial entrenchment.

18. While it is true that the risks faced by an investor of private equity into a buyout have a
different source than the risks faced by an investor into an IPO, this does not necessarily
imply that the risk will be significantly less. While a buyout will typically involve an
established business rather than a new enterprise, the returns to the investor are
contingent upon increasing the cash flows from the business unit through increased
efficiencies, more effective managerial incentive structures, etc. It is not clear whether the
variability of these incremental cash flows is any less than the variability of returns to
subscribers to an IPO.

19. There have been a number of explanations for the rise in buyout activity between the years
2000 and 2006, and the subsequent fall in activity in 2007. The most obvious explanation
is the level of interest rates and, more generally, the ready availability of the debt funding
needed to support buyout activity. Another possible explanation relates to the relative
valuation of firmsas measured by metrics such as the ratio of enterprise value
(calculated as the sum of the market values of debt and equity) to EBITDA (earnings
before interest tax depreciation and amortisation). During times when firm earnings are
priced more cheaply on markets we see a surge in buyout activity, whereas this trend
tends to reverse when earnings valuations are more expensive.

20. This point is discussed in section 19.7.3 and relates to the relatively high levels of debt
employed in buyout transactions. Management will be under pressure to cut costs and
increase efficiencies so as to generate sufficient cash to enable the entity to pay down its
debt.

21. There are substantial takeover-related increases in the value of the corporate economy.
For target companies, S. Bishop, P. Dodd and R.R. Officer (Australian takeovers: the
evidence 19721985, Policy Monograph, 12, Centre for Independent Studies, St
Leonards, 1987) found that:
(a) abnormal returns averaged 21 per cent over the 7-month period around the takeover
announcement; and
(b) the initial increase in wealth of a target companys shareholders appears to be
maintained even when the takeover bid is unsuccessful.

For acquiring companies, Bishop, Dodd and Officer found that:

(a) on average, shareholders of acquiring companies earn positive abnormal returns in the
years before the takeover bid is made;

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 (b) in the 7-month period around the announcement of the bid, the average abnormal
return for all bidders was 6.0 per cent; and
(c) the value added to shares of bidders appears to represent a permanent increase in
shareholders wealth.

Bishop Dodd and Officer estimated that the 1 442 bids covered by their study increased
the value of issued shares by $7.2 billion. A later study by P. Brown and R. da Silva Rosa
(Takeovers: who wins?, JASSA, Summer, 1997, pp. 25) reported an increase in
shareholders wealth of approximately $15 billion for the 1 528 target companies in their
sample.

22. Alternative explanations for the share price behaviour associated with unsuccessful
takeover bids are:

(a) The takeover bids resulted in release of information that contributed to a reappraisal
of the values of the target companies.
(b) Some of the unsuccessful target companies are expected to receive higher, possibly
successful, takeover bids within a few years of the initial bid.

As discussed in Section 19.8.1, the evidence is consistent with the second explanation.

23. As discussed in Section 19.8.6, the evidence reviewed by Jarrell, Brickley and Netter
provides little support for the argument that the gains to target company shareholders
result from wealth transfers rather than real economic gains. More direct evidence is
provided by Healy, Palepu and Ruback who found that, on average, operating cash flows
increased, post-merger, relative to other companies in the same industries. The higher cash
flows were attributable largely to increased asset productivity.

Solutions to problems

1. Using the CAPM:

kX = 0.10 + 1.0 (0.06)
= 0.16

$0.64m
VX =
0.16
= $4m

The value of X as an independent entity is $4m, and it is a zero NPV investment at that
price. Since the takeover is not expected to change the companys net cash flows, there is
no gain from the takeover and no benefit to Ys shareholders.

2. There are two ways that students may have approached this problem. The first way
involves students implicitly assuming that the extra $150 000 per annum is generated
solely from activities undertaken by Xavier Ltd, and hence the appropriate discount rate is
that relating to the systematic risk of Xavier Ltdwhich we calculated as 16% in
Problem 1.

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 It follows then that:

$150000
Gain =
0.16
= $937 500
The value of X to Y is $(4 + 0.9375)m, so Ys shareholders will benefit from the takeover
provided that X is acquired for less than $4.9375m.

Alternatively, if we were to assume that the extra cash flows are generated by the firms
combined operations, then it would be necessary to estimate the required rate of return
for the merged entity. To do this, we first need to estimate the required return for Yam Ltd
shares as well as the market value of its equity prior to the merger.

Using the CAPM:

kY = 0.10 + 0.75 (0.06)
= 0.145

$1160000
VY =
0.1475
= $8m

Therefore, the beta of the merged entity can be calculated as the weighted average beta of
the two constituent firms, where the weightings used reflect the relative values of the two
firms operating independently.

Therefore, the merged entity beta can be calculated as:

$8m $4m
Merged 0.75 1 0.8333
$12m $12 m

We then use the CAPM to estimate the appropriate discount rate:

kM = 0.10 + 0.8333 (0.06)

= 0.15

And the value of the synergistic benefits is then calculated as:

$150000
VSynergies=
0.15
= $1m

The value of X to Y is $(4 + 1)m so Ys shareholders will benefit from the takeover
provided that X is acquired for less than $5m.

3. (a) It is invalid to apply one companys priceearnings ratio to another company which
may have different risk and growth prospects. Also Winged Keels latest earnings may
not be representative of future earnings.
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 (b) Total tangible assets ignores liabilities and intangible assets. The valuation appears
to be based on book values. Problems associated with book values are outlined in the
answer to Question 10(b).
(c) The approach is conceptually sound, since dividends are the cash flows to
shareholders. Its accuracy depends on reliability of estimates of the discount rate and
forecasts of future dividends. It would be the most appropriate of the three
approaches.
4. (a) NPV = present value of after-tax cash flows minus initial outlay.
Years 15 $
Cash flow before tax 500 000
Depreciation ($2 000 000 0.2) 400 000
Taxable income 100 000
Tax (33%) 33 000
Net cash flow after tax 467 000
Years 625
Taxable income = before-tax cash flow 500 000
Tax (33%) 165 000
Net cash flow after tax 335 000
PV of cash inflows = 467 000A(5, 0.12) + $335 000A(20, 0.12)(1.12)5
= $3 103 282
Initial outlay = $2 900 000 (cash paid plus liabilities assumed)

The NPV of the takeover is $203 282, which is positive, but small in relation to the
investment. Squire would be well advised to analyse the source(s) of takeover
benefits very thoroughly.

5. (a) Gain = PV of savings

$250 000
=
0.1
= $2.5m

(b) Net cost of cash offer = premium paid over value of Sharkthat is, $2m.

(c) For the share-exchange offer, using Equation 19.5:

True cost = b PVcs PVs
b = 0.5 (given in question)
PVcs = 10 + 5 + 2.5
= $17.5m
True cost = (0.5 17.5) 5
= $3.75m (which also equals the gain to Sharks
shareholders)

(d) From the point of view of Crocodile:

(i) NPV = $(2.5 2.0) m
= $0.5m
(ii) NPV = $(2.5 3.75) m
= $1.25m

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 NPV to Crocodile becomes negative in this case because of the gain of $3.75m
accruing to Sharks shareholders.

6. (a) For the merged company:

Price per share $17.10
P/E ratio 12.86
Number of shares 263 158
Total earnings $350 000
Total market value $4 500 000

(b) 0.816 Progressive shares for every Lo-Gear share.

(c) True cost of takeover to Progressive:

163 158
$4 500 000 $2 500 000
263 158
= $290 000

(d) Original market value = $2 000 000

New value = 100 000 $17.10 = $1 710 000
Decrease in value = $290 000
This confirms the answer to part (c).

(e) If a takeover is economically viable, the benefits should be reflected in increased

earnings, so the effect on earnings per share will be one of the factors to be
considered in evaluating a bid. Inherent problems include the following:
(i) the benefits may take many years to flow through fully into earnings; and
(ii) where the two companies have different P/E ratios, it is possible, as in this case,
to arrange a share-exchange takeover which produces an immediate increase in
EPS even though there are no economic benefits at all (bootstrapping).
Therefore, it is desirable to focus attention on reasons why the companies should be
worth more when combined than when separate, rather than relying on EPS
comparisons.

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