Principles of Corporate Finance Unit L Lectures PDF

M&A Taxonomy Recent Mergers Largest mergers (1998 to 2015): 1 1 Source: Berk and DeMarzo Terminology • Merger • Two firms combine to form a single firm • Implies a “marriage of equals” • Takeover • One firm (“acquirer”) buys a sufficient number of shares or assets of another firm (“target”) t...

M&A Taxonomy Recent Mergers Largest mergers (1998 to 2015): 1 1 Source: Berk and DeMarzo Terminology • Merger • Two firms combine to form a single firm • Implies a “marriage of equals” • Takeover • One firm (“acquirer”) buys a sufficient number of shares or assets of another firm (“target”) to gain control • Not a marriage of equals – the management of the target is subordinate to that of the acquirer • Buyout • A (publicly traded) firm (or a division of a firm) is bought and then taken private. Types of Mergers Horizontal Mergers Vertical Mergers Firms that are in the same industry, and the same stage of production process. Firms that are in the same industry but at different stages of the production process Conglomerate Mergers Firms that are in different industries Takeovers • Friendly: The board of directors of two firms agree to combine and seek shareholders’ approval for the combination (generally more than 50%). • Hostile • Raider can make an offer to board of directors. • Raider can make an offer directly to shareholders (“tender offer”). • A hostile takeover attempt will often result in the target firm being sold to a friendly third party, called a “white knight”. Payment Methods • Cash deals • Target shareholders receive cash compensation. • For example, every share of the target receives $10 • Similar to selling the shares to the acquirer • Stock deals (“stock swap”) • Target shareholders receive payment in the form of the acquirer’s stock • For example, every share of the target receives 0.3 share of the acquirer’s (post-merger company) • Combination of cash and stock • Does payment method matter? • Not in an MM world (ie, without frictions) • In reality, yes Historical Perspective: US Six waves 1. 1893 to 1904: horizontal mergers with the explicit objective of creating monopolies 2. 1915 to 1929: horizontal mergers of secondary firms resulting in oligopolies 3. 1960s to 1970s: mostly conglomerate mergers (logic: create internal capital markets) 4. 1980s: many gigantic mergers with more underlying business logic than the previous wave. Mergers were relatively hostile 5. 1990s: mega-deals fuelled by globalisation; less hostile; more stock-financed purchases 6. 2000s: more buyouts due to the growth in private equity Historical Perspective: Europe Two waves 1. 1984 to 1989: mostly transatlantic acquisitions by US acquirers 2. 1993 to 2001: a surge in intra-European transactions; a significant component of the activity involved cross-border acquisitions; the Euro and deregulation/privatisation played particularly important roles compared to corresponding US activity The End Motivations for M&A Valid Sources of Value • Necessary restructuring: If restructuring through mergers is cost-effective, then it will add value. • Obsolete product • Increased foreign competition (eg, textiles) • Deregulation (eg, banking, airlines) • Market power: If you cannot undercut competitors, buying them could be an alternative. • Fewer participants allows monopoly pricing; stock price increase incorporates higher profits • Good for the companies, bad for society Valid Sources of Value (cont.) • Synergies/strategic benefits and economies of scale/scope (higher cash flows, ie, increase revenue, lower costs) • Transfer technology • Allows small firms to gain access to distribution and advertising • Easier to enter a new market • Reduction in taxes • Interest tax shields (technically an advantage of debt, not merger) • Reorganise into a trust or partnership • Other tax tricks • Realign managements’ incentives • • • • Replace bad managers Alternatives: proxy contests, compensation, etc Prevent empire building Prevent entrenched management, captured board Dubious Sources of Value, Part I • Increase financial slack (ie, get cash) • Managers may reject profitable investment opportunities if they have to raise new capital to finance them (pecking order theory). • Does this make any sense? It costs about a pound to buy a pound. • Diversification • Combining several industries to lower total risk is diversification at the firm level. • Do investors need it? They can diversify by holding a portfolio (more cheaply). Dubious Sources of Value, Part II • Buy a low price target to boost EPS? Acquiring firm has low E/P ratio Selling firm has high E/P ratio (perhaps due to low growth expectations) After merger, acquiring firm has shortterm EPS rise Long term, acquirer will have slower than normal EPS growth due to share dilution Dubious Sources of Value, Part III • CEO overconfidence: • CEOs are often overconfident in their management abilities and might overestimate potential gains (Roll’s hubris hypothesis). • “Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T[arget]. . . We’ve observed many kisses but very few miracles” (Warren Buffet, 1981). The End NPV Analysis of M&A Estimating Merger Gains Let ‘A’ denote the acquirer, ‘T’ the target, and ‘AT’ the combined entity (ie, the acquirer, post-acquisition). From the acquirer’s perspective: • Gain from merger: Gain = VAT − (VA + VT ) • Cost of cash-financed merger: Cost = Cash paid − VT • NPV of acquisition: NPV = Gain − Cost Estimating Merger Gains (cont.) • Start with the target’s stand-alone market value VT and concentrate on the changes in cash flow that would result from the merger. • You add value only if you can generate additional economic rents. • If the merger is financed by the acquirer’s stock, and sellers receive N shares in the merged company, then cost depends on the value of the shares in the new company: Cost = (N × PAT ) − VT • Due to asymmetric information, optimistic managers prefer to finance mergers with cash. The End Modelling 1: M&A Math Quick Question • The market values of the buyer and seller are £2 billion and £1.1 billion, respectively. • The buyer thinks that the combined companies can cut operating costs by £40 million per year in perpetuity. • The buyer reckons that a successful cash bid will probably cost £1.4 billion. • It might instead offer the seller’s shareholders a 33% stake in the merged firm. • Assume cost of capital at 11%. • Analyse the gain, costs, and NPVs of the two alternatives to pay. Answer to Quick Question • Gain from merger: £40m = £0.364 billion 0.11 • Cost of cash offer: £1.4 − 1.1 = £0.3 billion • Cost of stock offer: 0.33 × (2 + 1.1 + 0.364) − 1.1 = £0.043 billion • NPV of cash offer: 0.364 − 0.3 = £0.064 billion • NPV of stock offer: 0.364 − 0.043 = £0.321 billion The End Valuation in M&A DCF/NPV Analysis Pros • Construct transparent spreadsheet of free cash flows • CF comes from specific forecasts and assumptions • Can see impact of changes in strategies • Valuation tied to underlying fundamentals Cons • CF only as good as your forecasts/assumptions • Might “forget something” • Need to forecast managerial behaviour (unless you are in control) • Need to estimate the discount rate using a theory (eg, CAPM) that may be incorrect or imprecise Valuation by Multiples Assess the firm’s value based on that of publicly traded comparables. • Cash-flow-based value multiples • MV of firm/Earnings, MV of firm/EBITDA, MV of firm/FCF • Cash-flow-based price multiples • Price/Earnings (P/E), Price/EBITDA, Price/FCF • Asset-based multiples • MV of firm/BV of assets, MV of equity/BV of equity Valuation by Multiples: Procedure • Hope: Firms in the same business have similar multiples (eg, P/E). • Step 1: Identify firms in the same business as the firm you want to value. • Step 2: Calculate the P/E ratio for comparables and come up with an estimate of the P/E for the firm you want to value (eg, take the average of the comparables’ P/E). • Step 3: Multiply the estimated P/E by the actual EPS of the firm you want to value. Quick Example • Suppose Google’s market capitalisation (market value of equity) is $300 billion and it has 400 million shares. Its earnings per share was $75 last year. • Further assume Facebook is similar to Google and Facebook has earned $9.50 per share. • Price Facebook shares by E/P ratio. Quick Example: Answer • Google’s share price: 300b = $750 400m • Google’s E/P ratio: (E/P)Google = 75 = 0.1 750 • FB’s estimated share price: (E/P)FB = 0.1 → PFB = 9.5 = $95 0.1 Valuation by Multiples Pros • Incorporates a lot of information from other valuations in a simple way • Embodies market consensus about discount rate and growth rate • Free ride on market’s information • Can provide discipline in the valuation process by ensuring that your valuation is in line with other valuations Cons • Implicitly assumes all companies are alike in growth rates, cost of capital, and business composition • Hard time incorporating firm specific information; particularly problematic if operating changes are going to be implemented • Accounting differences, particularly with earnings and equity-based measures; multiples of FCF and EBITDA preferable for this reason • Book values can vary across firms depending on age of assets • If everyone uses comparables, who actually does fundamental analysis? The End Empirical Facts Who Benefits From a Takeover? US Empirical Evidence Returns to bidders and targets: event study results 1973-79 1980-89 1990-1998 Target 24.8% 23.9% 23.3% Bidder -4.5% -3.1% -3.9% Combined 0.1% 3.2% 1.6% Hostile 8.4% 14.3% 4.0% Own Industry 29.9% 40.1% 47.8% All Cash 38.3% 45.3% 27.4% Premium 47.2% 37.7% 34.5% Announcement returns Deal characteristics Acquisition Premium Empirical Evidence • Stock vs cash offers • The market prefers cash. • The decline in the price of acquirers who issue stock instead of paying cash is consistent with a signalling explanation. • Competition • Having multiple bidders is good for sellers but bad for bidders. Bidder returns average −1.2% without competition and −5.1% with competition. • Relative size and division of gains • Who should receive most of the gains? • Relative size makes percentage division of gains deceptive. Targets are typically much smaller than acquirers. The End The Free-Rider Problem in M&A The Free-Rider Problem: Example • You are a shareholder of Trans American Airlines, whose stock is trading for $45/share. • You suspect management is not running TAA well and if run optimally it would be worth $60. • Ownership is widely dispersed and convincing all shareholders to vote out the current board is unlikely. • B.Tyler Capital is known for raiding and turning around underperforming airlines by replacing and properly incentivising management. • B.Tyler makes a tender offer of $X/share for TAA. • B.Tyler can only turn around TAA if they are able to purchase enough shares (ie, 50% + 1). • How high must X be to entice enough shareholders to sell? The Free-Rider Problem: Example (cont.) • How about X = $45? (Current market price) • You can always sell for $45, but if B.Tyler succeeds in the takeover, your shares will jump to $60. • Similarly, if you think B.Tyler will succeed, there is no reason for you to sell for anything below $60. • If everyone thinks like you do, B.Tyler succeeds only if it offers $60/share. • However, at $60/share, B.Tyler makes no profits! • If there are transaction costs, B.Tyler will pay $60 plus costs and receive a firm worth $60. The Free-Rider Problem: Logic • Only the raider can unlock the extra value in the target firm. • However, the current shareholders will want to “free-ride” on the raider’s efforts. • The result is that: • Raiders overpay, reducing profits to themselves, or • No raid happens at all. • If all shareholders are rational and homogenous, the only equilibrium is no raids. • With heterogeneous beliefs, some raids will occur but it will be too few and the raider will overpay. • The free-rider problem explains why target prices jump up on a takeover announcement and why most of the gains go to the initial shareholders and not the acquirer. The End Failed Mergers Success and Failure Failed Attempts • Sometimes M&A deals fall apart. The stock price of the target drops when the deal falls through. What does this say about mispricing as a motivation for merger activity? • Unrealised gains in unrealised mergers implies that the bidder’s expertise or assets were needed, otherwise the old management continues to perform badly. • Merger arbitrage: When the value of the bidder’s offer is more than its proposed stake in the target is currently worth. • Why is this a “risky arbitrage opportunity”? The End Takeover Defences Takeover Defences Examples of takeover defences • Targeted repurchase: bribe the raider to go away (“greenmail”) • Average premium: 16% to bidder • Comes from existing shareholders’ wealth • File antitrust suit to block acquisition • Anti-takeovers amendments (“shark repellents”) • Poison pill (rights issue at a deeply discounted price) • Staggered terms for board of directors • Super majority provisions • ESOPs (employee stock ownership plan): Put votes in the hand of employees • Look for friendly alternatives (“white knights”) Takeover Defences (cont.) • If target shareholders gain in a takeover, why do managers of targets sometimes put up a fight? • Arguments for takeover defences • Bargaining power • Managers extract more value from bidders • Preservation of valuable long-term contracts • Managerial myopia • Managers would focus on long-term objectives if they are protected from takeovers • Evidence • Pstock drops 1.3% on announcement of anti-takeover amendment • Pstock drops 2% when poison pill is announced • Pstock up when board has majority of outside directors • Pstock down when board is controlled by insiders The End