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1. INTRODUCTION
Mergers and acquisitions (M&A) are complex, involving many parties.
Mergers and acquisitions involve many issues, including
- Corporate 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.
EXAMPLE OF A MERGER:
AMR AND U.S. AIRWAYS
Acquisition
Characteristic
Example
Horizontal
merger
Vertical merger
Conglomerate
merger
Companies are in
unrelated lines of
business.
Berkshire Hathaway
acquires Lubrizol (2011).
Company One
Post-Acquisition
$100 million
$50 million
$150 million
100 million
50 million
125 million
$1
$1
$1.20
P/E
20
10
20
$20
$10
$24
$2,000 million
$500 million
$3,000 million
Company One
Earnings
Number of shares
Assumptions:
Exchange ratio: One share of Company One for two shares of Company Two
Market applies weighted average P/E to the post-merger company.
Company Two
Company One
Post-Acquisition
$100 million
$50 million
$150 million
100 million
50 million
125 million
$1
$1
$1.20
P/E
20
10
16.67
$20
$10
$20
$2,000 million
$500 million
$2,500 million
Company One
Earnings
Number of shares
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Industry exhibits
Explosive growth in sales may
high profit margins require large capital requirements
caused by few
to expand existing capacity.
participants in the
market.
Conglomerate
Horizontal
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Industry faces
increasing
competition and
capacity
constraints.
Types of
Mergers
Horizontal
Vertical
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Types of
Motives for Merger
Mergers
Horizontal mergers may be
Horizontal
undertaken to ensure survival.
Vertical
Vertical mergers may be carried out Conglomerate
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.
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4. TRANSACTION CHARACTERISTICS
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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.
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METHOD OF PAYMENT
Cash offering
- Cash offering may be cash from
existing acquirer balances or from a
debt issue.
Securities offering
- Target 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.
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MINDSET OF MANAGERS
Friendly merger: Offer made through
the targets board of directors
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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.
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TAKEOVER DEFENSES
Pre-Offer Takeover Defense
Mechanisms
Poison pills (flip-in pill and flip-over
pill)
Poison puts
Litigation
Greenmail
Share repurchase
Leveraged recapitalization
Pac-Man defense
Golden parachutes
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6. REGULATION
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ANTITRUST
The 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.
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THE HHI
The HerfindalhlHirschman Index (HHI) is a measure of concentration within
an industry and is often used by regulators to evaluate the effects of a merger.
The HHI is constructed as the sum of the squared market shares of the firms in
the industry:
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EXAMPLE: HHI
Consider an industry that has six companies. Their respective market shares are
as follows:
Company
Market Share
A
25%
B
15%
C
15%
D
15%
E
15%
F
15%
100%
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EXAMPLE: HHI
Market
Company Share
HHI
Before
Market
Company Share
HHI
After
25%
625
25%
625
15%
225
15%
225
15%
225
15%
225
15%
225
15%
225
15%
225
E+F
30%
900
15%
225
Total
100%
1125
Total
100%
1575
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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.
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$40
Interest expense
$5
Depreciation
Interest income
$2
Assumed
Capital expenditures
$3
$10
$6
$20
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EXAMPLE: FCF
Net income
Plus
Equals
Plus
Equals
Plus
Depreciation
Minus
Minus
Capital expenditures
Equals
$40.00
1.65
$41.65
3.00
$44.65
10.00
6.00
20.00
$28.65
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Average of Comparables
Earnings
$10 million
P/E of comparables
30 times
Cash flow
$12 million
P/CF of comparables
25 times
$50 million
P/BV of comparables
2 times
Sales
$100 million
P/S of comparables
2.5 times
If the typical takeover premium is 20%, what is the XYZ Companys value in a
merger using the comparable company approach?
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Estimated
Stock Value
Earnings
$10 million
30
$300 million
Cash flow
$12 million
25
$300 million
$50 million
$100 million
$100 million
2.5
$250 million
Sales
Average =
$237.5 million
Estimated takeover price of the XYZ Company = $237.5 million 1.2 = $285 million
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Collect
Information on
Recent Takeover
Transactions of
Comparable
Companies
Calculate
Multiples for
Comparable
Companies
Estimate
Takeover Value
Based on
Multiples
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EXAMPLE: COMPARABLE
TRANSACTION ANALYSIS
Suppose an analyst has gathered the following information on the target
company, the MNO Company:
MNO Company
Average of Multiples of
Comparable Transactions
Earnings
$10 million
P/E of comparables
15 times
Cash flow
$12 million
P/CF of comparables
20 times
$50 million
P/BV of comparables
5 times
P/S of comparables
3 times
Sales
$100 million
Estimate the value of the MNO Company using the comparable transaction
analysis, giving the cash flow multiple 70% and the other methods 10% each.
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EXAMPLE: COMPARABLE
TRANSACTION ANALYSIS
Comparables
Transaction
Multiples
Estimated
Stock Value
Earnings
$10 million
15
$150 million
Cash flow
$12 million
20
$240 million
$50 million
$250 million
$100 million
$300 million
Sales
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EVALUATING BIDS
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(10-7)
where
PT = price paid for the target company
VT = pre-merger value of the target company
(10-8)
where
S = synergies created by the business combination
VA* = VA + VT + S C
(10-9)
where
VA* = post-merger value of the combined companies
VA = pre-merger value of the acquirer
C = cash paid to target shareholders
Copyright 2013 CFA Institute
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9. CORPORATE RESTRUCTURING
A divestiture is the sale, liquidation, or spin-off of a division or subsidiary.
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FORMS OF DIVESTITURE
1. Sale 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)
2. 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.
3. Liquidation: Breaking up the entity and selling off its assets piecemeal
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10. SUMMARY
An 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.
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SUMMARY (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.
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SUMMARY (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 Institute
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SUMMARY (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.
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