1

Chapter 6
Mergers and International Finance

 Required readings:
 Ehrhardt, M.C. Brigham, E. F. (2011), Financial Management: Theory
and Practice, 13th Ed., South-Western Cengage Learning. (Chapter
17,18,21,22& 23)
 Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan (2013),
Fundamentals of Corporate Finance, 10th ed. McGraw-Hill. (Chapter 21)
 Topics to be covered
2

 Merger and acquisitions

 Bankruptcy
 Multinational/International finance
 Specialized financing (options, lease)
 Mergers and Acquisitions
3

 Merger is any combination that forms one economic

unit from two or more previous ones.
 The primary motives behind corporate mergers;

Synergy
 To increase the value of the combined enterprise.

 If synergy exists, then the whole is greater than the

sum of the parts, “2 plus 2 equals 5 effect”.

 If Companies A and B merge to form Company
C & C’s value exceeds that of A & B taken
together.
 Cont’d……….
4

 Synergistic effects can arise from five sources:

 Operating economies - economies of scale in
management, marketing, production, or distribution;
 To gain economies of scale or scope and thus be

better able to compete in the world economy.

 Financial economies - lower transaction costs and
better coverage by security analysts.
 They contend that diversification helps stabilize a

firm’s earnings and thus benefits its owners.

 Cont’d………
5

 Tax effects - the combined enterprise pays less taxes

than the separate firms would pay;
 Tax considerations have stimulated a number of

mergers.
 For example, a profitable firm in the highest tax
bracket could acquire a firm with large
accumulated tax losses.
 These losses could then be turned into immediate

tax savings rather than carried forward and used in

the future.
 Cont’d………
6

 Differential efficiency - the management of one firm

is more efficient and that the weaker firm’s assets
will be more productive after the merger.
 Increased market power due to reduced competition.

 Expected synergies are not always realized.

 Hostile Versus Friendly Takeovers
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 A company that seeks to acquire another firm is the

acquiring company
 The one seeks to be acquired is the target company.
 Friendly Takeover - an agreement is reached between
the acquiring and target company on the merger, then the
two management groups will issue statements to their
stockholders indicating that they approve the merger.
 Hostile Takeover - If the target company’s management
resists the merger. In this case, the offer is hostile, and
the acquiring firm must make a direct appeal to the
target firm’s stockholders.
 Cont’d.……… Merger Analysis
8

 Acquiring firm must answer two questions.

 How much would the target be worth after being
incorporated into the acquirer?
 This may be quite different from the target’s

current value, which does not reflect any post-

merger synergies or tax benefits.
 How much should the acquirer offer for the target?
 A low price is obviously better for the acquirer, but

the target won’t take the offer if it is too low.

However, a higher offer price could scare off
potential rival bidders.
 Cont’d……….
9

 There are two basic approaches use in merger

valuation:
 Discounted cash flow (DCF) techniques and

market multiple analysis.

 49.3% firms use discounted cash flow techniques,
33.3% use both DCF and market multiples, and
12.0% use market multiples.
 The market multiple approach assumes that a target is
directly comparable to the average firms in its
industry.
 Cont’d……….
10

 There are three widely used DCF methods:

 Corporate valuation method,
 Adjusted present value method, and
 Equity residual method, also called the “free cash

flow to equity” method.

 Adjusted Present Value (APV) Approach
11

 The value of operations’ is the sum of two

components:
 Unlevered value of the firm’s operations (i.e., the

firm has no debt), plus

 PV of interest tax savings, aka, interest tax shield

Voperations = VUnlevered + VTax shield

 The value of unlevered firm is the PV of the firm’s
FCF discounted at the unlevered cost of equity.
 The value of tax shield is the PV of interest tax
savings discounted at the unlevered cost of equity, rsU.
 Cont’d……….
12


FCF t
V Unlevered  t 1 (1  r sU ) t


TS t
V Tax shield  
t1 (1  r sU ) t

r sL  r sU  ( r sU  r d )( D / S )

r sU  W s r sL  W d rd
 Cont’d………
13

 APV technique is useful for valuing targets.

 The debt cost and capital structure associated with

a merger are generally more complex than for a

typical firm.
 The easiest way to handle these complexities is to

specify each year’s expected interest expense and

use APV method to find the value of the unlevered
firm and the interest tax shields separately, and
then sum those values.
 Cont’d……….
14

 Many acquisitions are difficult to value using the

corporate valuation model because
 Acquiring firms frequently assume the debt of the

target firm, so old debt at different coupon rates is

often part of the deal; and
 The acquisition is usually financed partially by

new debt that will be paid down rapidly, so the

capital structures’ proportion of debt changes
during the years immediately following the
acquisition.
 Free Cash Flow To Equity (FCFE) Approach
15

 FCF - cash flow available for distribution to all

investors.
 FCFE or the equity residual model is the cash flow
available for distribution to common shareholders.
 The value of equity from operations’ is the
discounted projected FCFEs at the cost of equity.
 The uses of FCFE include all those of FCF except for
distributions to debt-holders.
 Cont’d………
16

FCFE = FCF − After-tax − Principal + Newly issued

interest exp. payments debt
= FCF − interest exp. + Interest + Net Change
Tax-shield in debt

 Alternatively, FCFE can be calculated as

FCFE = NI − Net investment in + Net change
operating capital in debt
 The value of a firm’s equity from operations, VFCFE,

FCFE
V FCFE   t

t  1 (1  r sL ) t
 Cont’d……….
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 If we assume constant growth beyond the horizon,

the horizon value of the equity due to operations,
HVFCFE, N;
FCFE N 1 FCFE N (1  g)
HV  
FCFE, N rsL - g rsL - g

 The value of equity due to operations is the PV of

horizon value and FCFE during the forecasted
period: HV FCFE, N
N
FCFE t
V
FCFE
 
t 1 (1  r sL ) t

(1  r sL ) t
 Cont’d……….
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 Total value of a company’s equity, S, is the value of

the equity from operations plus the value of any non-
operating assets:
S = VFCFE + Non-operating assets

 Like the corporate valuation model, the FCFE model

can be applied only when the capital structure is
constant.
 Cont’d……….
19

Illustration
 Fine Inc. evaluates a potential acquisition of Bayer

co. Bayer currently has a $62.5 million market value

of equity and $27 million in debt (total market value
of $89.5 million). Thus, Bayer’s capital structure
consists of $27/($62.5 + $27) = 30.17% debt. Fine
intends to finance the acquisition with the same
proportion of debt and plans to maintain this capital
structure throughout the projection period and
thereafter.
 Cont’d………
20

 Bayer is a publicly traded company, and its pre-

merger beta was 1.2, risk-free rate of 7% and a 5%
market risk premium.
 CAPM produces a pre-merger required rate of return
on equity, rsL, of
rsL = 7% + 1.2(5%) = 13%
 Bayer’s rd is 9% and tax rate is 40%. Its WACC is
WACC = wdrd (1 − T) + wsrsL
=0.3017(9%)(0.6) + 0.6983(13%)
=10.707%
 Cont’d………
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How much would Bayer be worth to Fine after the

merger?
 All three models produce an identical value of equity

under the constant capital structure.

 If the capital structure were to change during the

projection period before becoming stable, then only

the APV model could be used.
 The first task is to estimate the post-merger cash

flows that Bayer will produce.

 The post-merger cash flows are extremely difficult

to estimate.
 Cont’d……..
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Additional information of Bayer in the post-merger

 Both Fine and Bayer are in the 40% tax bracket.

 The cost of debt after the acquisition will remain at

9%.
 The projections assume that growth in the post-

horizon period will be 6%.

 Cont’d…Post-Merger Projections for Bayer
Subsidiary (in Millions)
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F/S 1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15

1 Interest 3.0 3.2 3.5 3.7 3.9
Expense
2 Debt 33.2 35.8 38.7 41.1 43.6 46.2
3 FCF 3.2 3.2 5.6 6.4 6.8
4 Interest tax 1.2 1.3 1.4 1.5 1.56
saving
5 After Tax 1.8 1.9 2.1 2.2 2.4
interest
6 Change in 6.2 2.6 2.9 2.5 2.5 2.6
debt
7 FCFE 6.2 4.0 4.1 6.0 6.7 7.1
 Cont’d……….
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Corporate Valuation Model

 The horizon value of Bayler’s operations as of 2015

can be calculated with the constant growth formula:

FCF2016 FCFE 2015 (1  g)
HV  
Operations , 2015 WACC - g WACC - g
6.800(1.06 )
HV   $ 153 .1 millions
Operations , 2015 0.10707 - 0.06
 The value of operations as of January 1, 2011, is the
present value of the cash flows in the forecast period
and the horizon value:
 Cont’d……….
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3.2 3.2 5.6

V   
Operations (1  0.10707)1 (1  0.10707)2 (1  0.10707)3

6.4 6.8  153.1

 
(1  0.10707) (1  0.10707)5
4

 $110.1 millions
 There are no non-operating assets, so the value of
equity to Fine if Bayer is acquired is equal to the
value of operations less the value of Bayer’s debt:
$110.1 − $27 = $83.1 million
 Cont’d………
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Valuation Using APV Approach

 APV approach requires to estimate Bayer’s unlevered

cost of equity.
r sU  W s r sL  W d r d
= 0.6983(13%) + 0.3017(9%)
= 11.793%

 If Bayer had no debt, its cost of equity would be

11.793%.
 Cont’d………
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 The horizon value of Bayer’s unlevered cash flows

(HVU,2015) and tax shield (HVTS,2015)
FCF 2016 FCF (1  g )
HV U,2015   2015

r sU  g r sU  g

6.80(1.06)

0 . 11793  0 . 06
 $ 124 . 4 million
TS 2016 TS (1  g )
HV TS,2015   2015

r sU  g r sU  g

1.56(1.06)

0 . 11793  0 . 06
 $ 28 . 7 million
 Cont’d………
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 The sum of the two horizon values is $124.4 + $28.7

= $153.1 million.
 This is the HV of operations, the same as the

horizon value with the corporate valuation model.

 Unlevered value of operations = PV of FCF during
the forecasted period and the HV of the FCF
3.2 3.2 5.6
VUnlevered   
(1  0.11793) 1
(1  0.11793) 2
(1  0.11793) 3
6.4 6.8  124.4
 
(1  0.11793) 4
(1  0.11793) 5
 $88.7 millions
 Cont’d………
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 The value of the tax shield is calculated as the PV of

the yearly tax savings and the horizon value of the
tax shield:
1.2 1.3 1.4
VTax Shield   
(1  0.11793) (1  0.11793) (1  0.11793)3
1 2

1.5 1.56  28.7

 
(1  0.11793) (1  0.11793)5
4

 $21.4 millions
 Cont’d……..
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 Bayer’s operations would be worth only $88.7

million if it had no debt.
 But its capital structure contributes $21.4 million

in value due to the tax deductibility of its interest

payments.
 The value of the firm is the sum of unlevered value
of operations and tax shield (88.7m + 21.4m =
110.1m.
 The value of the equity: $110.1 − $27 = $83.1
million.
 This is the same value with the corporate valuation
 Cont’d…….
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Valuation Using the FCFE Model

 The horizon value of Bayer’s FCFE

FCFEN (1  g) 7.01(1.06)
HV    $106.9 million
FCFE, 2015 rsL - g 0.13 - 0.06
 The horizon value is different from the APV and
corporate valuation horizon values.
 The FCFE horizon value is only for equity,

whereas the other two horizon values are for the

total value of operations.
 Cont’d………
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 The PV of the yearly FCFEs and the horizon value:

4.0 4.1 6.0
VFCFE  6.2   
(1  0.13) 1 (1  0.13) 2 (1  0.11793) 3
6.7 6.8  106.9
 
(1  0.13) 4
(1  0.13) 5
 $83.1 millions
 All models produce equity value ($83.1 million)
more than the current market value of Bayer’s equity
($62.5 million), i.e., more valuable as a part of Fine
than as a stand-alone co. being run by its current
managers.
 Cont’d……..
33

 The difference (83.1m - 62.5m = 20.6m) represents

synergistic benefits expected from the merger.
 Cont’d……….
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Setting the Bid Price

 The issue of how to divide the synergistic benefits is

critically important.
 Both parties would want to get the best deal possible.

From Fine Inc. angle:

 The valuation models show that $83.1 million is the

most it should pay for Bayer’s stock.

 If it paid more, Fine’s own value would be diluted.
 If it could get Bayer for less than $83.1 million,

Fine’s stockholders would gain value.

 Cont’d……..
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 Fine inc. try to get Bayer at a price as close to

$62.5 million as possible.
From Bayer company angle:
 Bayer’s value of equity as an independent operating

company is $62.5 million.

 If Bayer were acquired at a price greater than $62.5

million then its stockholders would gain value,

whereas they would lose value at any lower price.
 Bayer’s management would argue for a price close

to $83.1 million.
 Cont’d………
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 If there were no synergistic benefits, the maximum

bid would be the current value of the target company.
 The greater the synergistic gains, the greater the gap
between the target’s current price and the maximum
the acquiring company could pay.

Cash Offers versus Stock Offers

 Most target stockholders prefer to sell their shares for

cash rather than to exchange them for stock in the

post-merger company.
 Bankruptcy
37

Financial Distress
 A condition where a firm’s operating cash flows are

not sufficient to satisfy current obligations and the

firm is forced to take corrective action.
 Lead a firm to default on a contract, and it may

involve financial restructuring between the firm, its

creditors, and its equity investors.
 Why firms suffer financial distress?

 High leverage ratio

 Inferior operating results
 Declining of industry
 Cont’d………..
38

 Financial distress does not usually result in firm’s

death.
Firms deal with distress by
 Asset Restructuring:
 Selling major assets.
 Merging with another firm.
 Reducing capital and R&D spending.
 Financial Restructuring:
 Issuing new securities.
 Negotiating with banks and other creditors.
 Exchanging debt for equity.
 Filing for bankruptcy.
 Cont’d………
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Bankruptcy: Liquidation and Reorganization

 A firm is officially bankrupt when it files for

bankruptcy with a federal court.

 A legal process to get out of debt when you can no

longer make all your required payment.

 Formal bankruptcy proceedings are designed to

protect both the firm and its creditors.

 Bankruptcy court in a reorganization determines

the fairness and the feasibility of the proposed plan

of reorganization.
 If a company is “too far gone” to be reorganized,

then it must be liquidated.

 Cont’d……..
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 Reorganization is the option of keeping the firm a

going concern.
 Sometimes, it involves issuing new securities to

replace old ones.

 Liquidation means termination of the firm as a going
concern.
 It involves selling the assets of the firm for

salvage.
 The proceeds, net of transactions costs, are

distributed to creditors in order of priority.

 Cont’d……….
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 Liquidation should occur when

 The business is worth more dead than alive, or the

possibility of restoring it to financial health is

remote.
 The creditors are exposed to a high risk of greater

loss if operations are continued.

 Multinational/International finance
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 A multinational corporations are firms that operate in

an integrated fashion in a number of countries.
 It consists of a parent company located in the home
country and several foreign subsidiaries.
 Companies “go global” for many reasons;
 To broaden their markets
 To seek raw materials
 To seek new technology
 To seek production efficiency
 To avoid political and regulatory obstacles
 To diversify
 Cont’d………
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 Financial issues for the Multinational Firms

 Foreign exchange risk management
 Managing working capital
 Financing foreign units
 Capital budgeting
 Evaluation and control
 Financial Options
44

 Financial option is a contract that gives its owner the

right to buy or sell an asset at some predetermined
price within a specified period of time.
 The two primary types of financial options:
 Call option - an option to buy a specified number
of shares of a security within some future period.
 Put option - an option to sell a specified number of
shares of a security within some future period.
 Cont’d………
45

 Exercise (strike) price - the price stated in the

option contract at which the security can be
bought or sold.
 Option price - market price of the option
contract.
 Exercise value - value of option if it was
exercised today = Current price - Strike price.
 In-the-money - exercise value (intrinsic value) >
zero.
 Out-of-the-money – intrinsic value < zero.
 At -the-money - intrinsic value = zero.
 Cont’d………
46

 Each option has an expiration date, after which the

option may not be exercised.
 If the option can be exercised any time before the

expiration, called an American option.

 If the option can be exercised only on its expiration

date, it is an European option.

 Cont’d………
47

Example: Exercise price = 25.00 (b)

Stock Price Call Exercise Value of Profit (c -
(a) Option Option(a - b) or (e) e)
Market
Price (c)
25.00 3.00 0 -3.00
30.00 5.00 5.00 0
35.00 8.00 10.00 2.00
40.00 12.00 15.00 3.00
45.00 15.00 20.00 5.00
 Lease
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 A contract that conveys (transfers) to the customer

(lessee) the right to use an identified asset (the
underlying asset) for a period of time in exchange
for a consideration.
 Criteria
 There is an identifiable asset
 Lessee obtains economic benefits
 Lessee directs the use
 Evaluation of the Leases
49

 Leases are evaluated by both the lessee and the

lessor.
 The lessee must determine whether leasing an asset

is less costly than buying it.

 The lessor must decide whether the lease payments

provide a satisfactory return on the capital invested

in the leased asset.
 Cont’d……….
50

Evaluation by the Lessee

 The lease decision is typically a financing decision.

 Once the firm has decided to acquire the asset, the

next question is how to finance it.

 A lease is comparable to a loan in the sense that the

firm is required to make a specified series of

payments, and a failure to meet these payments could
result in bankruptcy.
 The most appropriate comparison is lease financing

versus debt financing.

 Cont’d…….
51

 Abdu Company needs a 5-years asset and the

company must choose between leasing and buying
the asset. Tax rate is 40%. If the asset is purchased,
bank would lend Abdu Company birr 12 million at
10% on a 5-years. The firm can lease it with birr 3
million in lease payment at the end of each year. The
asset’s value at the end of 5 years will be 0. Assume
Abdu Company can depreciate the asset over 5 years
for tax purposes by the straight-line. Tax rate is 40%.
 Should Abdu company lease or buy the asset?
 Cont’d……..
52

 The analysis for the lease-versus-borrow decision

consists of
 Estimating the cash flows associated with

borrowing and buying the asset;

 Estimating the cash flows associated with leasing

the asset; and

 Comparing the two financing methods to
determine which has the lower present value costs.
 Cont’d…….
53

Lease-versus-Buy Decision (Millions of Dollars)

Year
0 1 2 3 4 5
Cost of Leasing
Lease Payment (3.00) (3.00) (3.00) (3.00) (3.00)
PV of cash flow 0 (2.727 (2.478) (2.253) (2.049 (1.863)
) )
PV of leasing @ 10% 11.3
7
Cost of Leasing 11.3
7
Net advantage to leasing (NAL)
NAL = Cost of ownership − cost of leasing = 0.63
 Cont’d………
54

 The PV cost of owning exceeds the PV cost of

leasing, so the NAL is positive.
 Therefore, Abdu company should lease the asset.
 Cont’d……..
55

Questions!

Thank you!