Chapter 25
Mergers, LBOs, Divestitures, and Holding Companies
ANSWERS TO END-OF-CHAPTER QUESTIONS


25-1 a. Synergy occurs when the whole is greater than the sum of its parts. When applied to mergers, a synergistic merger occurs when the postmerger earnings exceed the sum of the separate companies' premerger earnings. A merger is the joining of two firms to form a single firm.

b. A horizontal merger is a merger between two companies in the same line of business. In a vertical merger, a company acquires another firm that is "upstream" or "downstream"; for example, an automobile manufacturer acquires a steel producer. A congeneric merger involves firms that are interrelated, but not identical, lines of business. One example is Prudential's acquisition of Bache & Company. In a conglomerate merger, unrelated enterprises combine, such as Mobil Oil and Montgomery Ward.

c. A friendly merger occurs when the target company's management agrees to the merger and recommends that shareholders approve the deal. In a hostile merger, the management of the target company resists the offer. A defensive merger occurs when one company acquires another to help ward off a hostile merger attempt. A tender offer is the offer of one firm to buy the stock of another by going directly to the stockholders, frequently over the opposition of the target company’s management. A target company is a firm that another company seeks to acquire. Breakup value is a firm’s value if its assets are sold off in pieces. An acquiring company is a company that seeks to acquire another firm.

d. An operating merger occurs when the operations of two companies are integrated with the expectation of obtaining synergistic gains. These may occur due to economies of scale, management efficiency, or a host of other reasons. In a pure financial merger, the companies will not be operated as a single unit, and no operating economies are expected.

e. The discounted cash flow (DCF) method to valuing a business involves the application of capital budgeting procedures to an entire firm rather than to a single project. The market multiple method applies a market-determined multiple to net income, earnings per share, sales, book value, or number of subscribers, and is a less precise method than DCF.

f. Under purchase accounting, the acquiring firm is assumed to have “bought” the acquired company in much the same way it would buy any capital asset. Any excess of the purchase price over the book value of assets is added to goodwill, which may be expensed for Federal income tax purposes, but may not be expensed for shareholder reporting.



g. A white knight is a friendly competing bidder that a target management likes better than the company making a hostile offer, and the target solicits a merger with the white knight as a preferable alternative.
A poison pill is a deliberate action that a company takes which makes it a less attractive takeover target. A golden parachute is a payment made to executives that are forced out when a merger takes place. A proxy fight is an attempt to gain control of a firm by soliciting stockholders to vote for a new management team.

h. A joint venture involves the joining together of parts of companies to accomplish specific, limited objectives. Joint ventures are controlled by the combined management of the two (or more) parent companies. A corporate or strategic alliance is a cooperative deal that stops short of a merger.

i. A divestiture is the opposite of an acquisition. That is, a company sells a portion of its assets, often a whole division, to another firm or individual. In a spin-off, a holding company distributes the stock of one of the operating companies to its shareholders. Thus, control passes from the holding company to the shareholders directly. A leveraged buyout is a transaction in which a firm's publicly owned stock is acquired in a mostly debt-financed tender offer, and a privately owned, highly leveraged firm results. Often, the firm's own management initiates the LBO.

j. A holding company is a corporation formed for the sole purpose of owning stocks in other companies. A holding company differs from a stock mutual fund in that holding companies own sufficient stock in their operating companies to exercise effective working control. An operating company is a company controlled by a holding company. A parent company is another name for a holding company. A parent company will often have control over many subsidiaries.

k. Arbitrage is the simultaneous buying and selling of the same commodity or security in two different markets at different prices, and pocketing a risk-free return. In the context of mergers, risk arbitrage refers to the practice of purchasing stock in companies that may become takeover targets.

25-2 Horizontal and vertical mergers are most likely to result in governmental intervention, but mergers of this type are also most likely to result in operating synergy. Conglomerate and congeneric mergers are attacked by the government less often, but they also are less likely to provide any synergistic benefits.

25-3 A tender offer might be used. Although many tender offers are made by surprise and over the opposition of the target firm's management, tender offers can and often are made on a "friendly" basis. In this case, management (the board of directors) of the target company endorses the tender offer and recommends that shareholders tender their shares.

25-4 An operating merger involves integrating the company's operations in hopes of obtaining synergistic benefits, while a pure financial merger generally does not involve integrating the merged company's operations.



SOLUTIONS TO END-OF-CHAPTER PROBLEMS



25-1 FCF1 = 2.00(1.05) = $2.1 million; g = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd = 30%; T = 40%; rd = 8% Vops = ? P0 = ?

rs = rRF + RPM(b)
= 5% + 6%(1.4)
= 13.4%.
WACC = wdrd(1-T) + wsrs
= 0.30(8%)(0.60) + 0.70(13.4%)
= 10.82%

Vops =
=
= $36.08 million
VS = Vops – debt
= 36.08 – 10.82 = $25.26 million
Price = 25.26 million / 1 million shares
= $25.26 / share.


25-2 FCF1 = $2.5 million, FCF2 = $2.9 million and FCF3 = $3.4 million; g = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd = 30%; T = 40%; rd = 8% Vops = ? P0 = ?

WACC was calculated in problem 1 to be 10.82%. Since the horizon capital structure is the same as in problem 1, the WACC is the same.

Horizon Value3 = FCF3(1+g)/(WACC – g)
= 3.4 (1.05)/(.1082 – 0.05)
= $61.34 million

Tax shields in years 1 through 3 are:
TS1 = TS2 = TS3 = Interest x T
= 1,500,000 x 0.40
= 600,000

FCF + Tax Shield + Horizon Value =
Year 1: 2.5 million + 600,000 = 3.1 million
Year 2: 2.9 million + 600,000 = 3.5 million
Year 3: 3.4 million + 600,000 + 61.34 million = 65.34 million




The unlevered cost of equity based on the pre-merger required rate of return and pre-merger capital structure is:

rsU = wdrd + wsrsL Note: rs was calculated in problem 1 to be 13.4%
= 0.30(8%) + 0.70(13.4%)
= 11.78%

The present value of the FCFs, the tax shields, and the horizon value at the unlevered cost of equity is:

Vops =
= $52.36 million

Equity value to Harrison = Vops – Debt
= 52.36 million - 10.82 million
= 41.54 million
or $41.54 per share since there are 1 million shares outstanding.


25-3 On the basis of the answers in Problems 25-1 and 25-2, the bid for each share should range between $25.26 and $41.54.





25-4 The difference between this problem and problem 25-2 is the discount rate used at the horizon. Since rsU = 11.78%, rsL with 45% debt and an 8.5% cost of debt is:

rsL = rsU + (rsU –rd)(D/S)
= 11.78% + (11.78% - 8.5%)(0.45/0.55)
= 14.46%
WACC = wdrd(1-T) + wsrs
= 0.45(8.5%)(1-0.40) + 0.55(14.46%)
= 10.25%

The new horizon value at this WACC is:
Horizon Value3 = FCF3(1+g)/(WACC – g)
= 3.4 (1.05)/(.1025 – 0.05)
= $68.0 million

The new present value is:
Vops =
= $57.13 million

The value of the equity is $57.13 million – 10.82 = 46.31 million, or $43.61 per share.




25-5 a. The appropriate discount rate reflects the riskiness of the cash flows. Thus, it is Conroy’s unlevered cost of equity that should be used to discount the free cash flows and tax shields in years 1-4. The horizon value should be calculated using Conroy’s WACC, adjusting for the increased leverage. Since Conroy’s b = 1.3, its current cost of equity, rsL = 6% + 1.3(4.5%) = 11.85%. Since its percentage of debt is 25% and the rate on its debt is 9%, its unlevered cost of equity is

rsU = wdrd + wsrsL
= 0.25(9%) + 0.75 (11.85%)
= 11.14%

At the new capital structure of 40 percent debt with a rate of 9.5 percent, the new levered cost of equity and WACC will be:

rsL = rsU + (rsU –rd)(D/S)
= 11.14% + (11.14% - 9.5%)(0.40/0.60)
= 12.23%
WACC = wdrd(1-T) + wsrs
= 0.40(9.5%)(1-0.35) + 0.60(12.23%)
= 9.81%

b. The horizon value is:
Horizon Value4 = FCF4(1+g)/(WACC – g)
= 2.0 (1.06)/(0.0981 – 0.06)
= $55.64 million

The interest tax shields are calculated as interest payment x Tax rate. These tax shields, free cash flows, and horizon value are to be discounted at the unlevered cost of equity:


Year 1 2 3 4 5
|--------|---------|---------|---------|---------|
Tax Shield 1.2(.35) 1.7(.35) 2.8(.35) 2.1(.35)
Free Cash Flow 1.3 1.5 1.75 2.0
Horizon Value 55.64
Total 1.72 2.10 2.73 58.38

The present value of these cash flows is the value of operations:

Vops =
= $43.50 million

Equity = Vops – debt
= $43.5 – 10 = $33.5 million is the maximum amount to pay.


25-6 a. The horizon value should be calculated using BCC’s WACC based on its new capital structure. The intermediate free cash flows, tax shields, and the horizon value should be discounted at BCC’s unlevered cost of equity. To calculate all of these items: First, find BCC's pre-merger cost of equity and unlevered cost of equity:

rsL = rRF + (RPM)b = 6% + (4%)1.40 = 11.6%.
rsU = wdrd + wsrsL = 0.40(10%) + 0.60(11.6%) = 10.96%

after the merger, BCC will have 50 percent of debt costing 10%, so its levered cost of equity and WACC will be:

rsL = rsU + (rsU –rd)(D/S)
= 10.96% + (10.96% - 10%)(0.50/0.50)
= 11.92%
WACC = wdrd(1-T) + wsrs
= 0.5(10%)(1-0.35) + 0.5(11.92%)
= 9.21%


































b. The free cash flows are NOPAT - net retentions = (Sales – CGS – selling expenses)(1-T) – net retentions. CGS is 65% of sales:


2005
2006
2007
2008
Net sales
$450.00
$518.00
$555.00
$600.00
Cost of Goods Sold
$292.50
$336.70
$360.75
$390.00
SGA
$45.00
$53.00
$60.00
$68.00
EBIT
$112.50
$128.30
$134.25
$142.00
Taxes on EBIT (35%)
$39.38
$44.91
$46.99
$49.70
NOPAT
$73.12
$83.39
$87.26
$92.30
Net Retentions
$50.00
$80.00
$75.00
$70.00
FCF
$23.12
$3.39
$12.26
$22.30



See part d for calculations of the tax shields.

c. Horizon value = 22.30(1.07)/(0.0921-0.07) = $1,079.68.

d. Vops = PV of FCF, Tax shield, and Horizon value at the unlevered cost of equity. The tax shields are interest x tax rate:


2005
2006
2007
2008
Interest
$40.00
$45.00
$47.00
$52.00
Tax shield
$14.00
$15.75
$16.45
$18.20
FCF
$23.12
$3.39
$12.26
$22.30
Horizon value



$1,079.68
Total CF
$37.12
$19.14
$28.71
$1,120.18


NPV of total FCF at unlevered cost of equity, 10.96%, = Vops = $808.08 = $0.809 million. Value of BCC’s equity = Vops – Debt = $0.809 million – $0.300 = $0.509 million.


SOLUTION TO SPREADSHEET PROBLEMS



25-7 The detailed solution for the problem is available both on the instructor’s resource CD-ROM (in the file Solution to FM11 Ch 25 P07 Build a Model.xls) and on the instructor’s side of the accompanying book site, http://brigham.swcollege.com.

MINI CASE


Hager’s Home Repair Company, a regional hardware chain, which specializes in “do-it-yourself” materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on a potential target, Lyons’ Lighting, a small chain which operates in an adjacent state, and he has enlisted your help.
The table below indicates Zona’s estimates of Lyons’ earnings potential if it came under Hager’s management (in millions of dollars). The interest expense listed here includes the interest (1) on Lyons’ existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to help finance expansion within the new “L division,” the code name given to the target firm. If acquired, Lyons' Lighting will face a 40% tax rate.
Security analysts estimate that Lyons’ beta is 1.3. The acquisition would not change Lyons’ capital structure. Zona realizes that Lyons’ Lighting also generates depreciation cash flows, all of which must be reinvested in the division to replace worn-out equipment. The net retentions in the table below are required reinvestment in addition to these depreciation cash flows. Zona estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. He also estimates that free cash flows after 2008 will grow at a constant rate of 6 percent. Following are projections for sales and other items.
2005 2006 2007 2008
Net sales $60.0 $90.0 $112.5 $127.5
Cost of goods sold (60%) 36.0 54.0 67.5 76.5
Selling/administrative expense 4.5 6.0 7.5 9.0
Interest expense 5.0 6.5 6.5 7.0
Required net retentions 0.0 7.5 6.0 4.5

Hager’ management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hager’s board.

a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.

Answer: The economically justifiable rationales for mergers are synergy and tax consequences. Synergy occurs when the value of the combined firm exceeds the sum of the values of the firms taken separately. (if synergy exists, then the whole is greater than the sum of the parts, and hence synergy is also called the "2 + 2 = 5" effect.)
A synergistic merger creates value, which must be apportioned between the stockholders of the merging companies. Synergy can arise from four sources: (1) operating economies of scale in management, production, marketing, or distribution; (2) financial economies, which could include higher debt capacity, lower transactions costs, or better coverage by securities' analysts which can lead to higher demand and, hence, higher prices; (3) differential management efficiency, which implies that new management can increase the value of a firm's assets; and (4) increased market power due to reduced competition. Operating and financial economies are socially desirable, as are mergers that increase managerial efficiency, but mergers that reduce competition are both undesirable and illegal.
Another valid rationale behind mergers is tax considerations. For example, a firm which is highly profitable and consequently in the highest corporate tax bracket could acquire a company with large accumulated tax losses, and immediately use those losses to shelter its current and future income. Without the merger, the carry-forwards might eventually be used, but their value would be higher if used now rather than in the future.
The motives that are generally less supportable on economic grounds are risk reduction, purchase of assets at below replacement cost, control, and globalization. Managers often state that diversification helps to stabilize a firm's earnings stream and thus reduces total risk, and hence benefits shareholders.
Stabilization of earnings is certainly beneficial to a firm's employees, suppliers, customers, and managers. However, if a stock investor is concerned about earnings variability, he or she can diversify more easily than can the firm. Why should firm a and firm b merge to stabilize earnings when stockholders can merely purchase both stocks and accomplish the same thing? Further, we know that well-diversified shareholders are more concerned with a stock's market risk than its stand-alone risk, and higher earnings instability does not necessarily translate into higher market risk.
Sometimes a firm will be touted as a possible acquisition candidate because the replacement value of its assets is considerably higher than its market value. For example, in the early 1980s, oil companies could acquire reserves more cheaply by buying out other oil companies than by exploratory drilling. However, the value of an asset stems from its expected cash flows, not from its cost. Thus, paying $1 million for a slide rule plant that would cost $2 million to build from scratch is not a good deal if no one uses slide rules.
In recent years, many hostile takeovers have occurred. To keep their companies independent, and also to protect their jobs, managers sometimes engineer defensive mergers, which make their firms more difficult to "digest." Also, such defensive mergers are usually debt-financed, which makes it harder for a potential acquirer to use debt financing to finance the acquisition. In general, defensive mergers appear to be designed more for the benefit of managers than for that of the stockholders.
An increased desire to become globalized has resulted in many mergers. To merge just to become international is not an economically justified reason for a merger; however, increased globalization has led to increased economies of scale. Thus, synergies often result--which is an economically justifiable reason for mergers. Synergy appears to be the reason for this merger.
b. Briefly describe the differences between a hostile merger and a friendly merger.

Answer: In a friendly merger, the management of one firm (the acquirer) agrees to buy another firm (the target). In most cases, the action is initiated by the acquiring firm, but in some situations the target may initiate the merger. The managements of both firms get together and work out terms which they believe to be beneficial to both sets of shareholders. Then they issue statements to their stockholders recommending that they agree to the merger. Of course, the shareholders of the target firm normally must vote on the merger, but management's support generally assures that the votes will be favorable.
If a target firm's management resists the merger, then the acquiring firm's advances are said to be hostile rather than friendly. In this case, the acquirer, if it chooses to, must make a direct appeal to the target firm's shareholders. This takes the form of a tender offer, whereby the target firm's shareholders are asked to "tender" their shares to the acquiring firm in exchange for cash, stock, bonds, or some combination of the three. If 51 percent or more of the target firm's shareholders tender their shares, then the merger will be completed over management's objection.


c. What are the steps in valuing a merger?
Answer: When the capital structure is changing rapidly, as in many mergers, the WACC changes from year-to-year and it is difficult to apply the corporate valuation model in these cases. The APV model works better when the capital structure is changing. The steps are:

Project FCFt ,TST , horizon growth rate, and horizon capital structure.
Calculate the unlevered cost of equity, rsu.
Calculate WACC at horizon.
Calculate horizon value using constant growth corporate valuation model.
Calculate Vops as PV of FCFt, TST and horizon value, all discounted at rsu.





d. Use the data developed in the table to construct the L division's free cash flows for 2005 through 2008. Why are we identifying interest expense separately since it is not normally included in calculating free cash flow or in a capital budgeting cash flow analysis? Why are net retentions deducted in calcuating free cash flow?

Answer: The easiest approach here is to calculate the free cash flows for the L division, assuming that the acquisition is made (in millions of dollars).
2005 2006 2007 2008
Net sales $60.0 $90.0 $112.5 $127.5
Cost of goods sold (60%) 36.0 54.0 67.5 76.5
Selling/admin. Expenses 4.5 6.0 7.5 9.0
EBIT 19.5 30.0 37.5 42.0
Taxes on EBIT(40%) 7.8 12.0 15.0 16.8
NOPAT 11.7 18.0 22.5 25.2
Net retentions 0.0 7.5 6.0 4.5
Free cash flow 11.7 10.5 16.5 20.7

Interest expense 5.0 6.5 6.5 7.0
Interest tax savings 2.0 2.6 2.6 2.8

Note that these free cash flows are identical to what you would construct to use the corporate valuation model or to use standard capital budgeting procedures, except that we have also included separate lines for the interest expense and interest tax savings (which are calculated as interest x tax rate and are also called interest tax shields). In many merger analyses the debt levels change so dramatically that using the corporate value model would require re-estimating the WACC every year. Instead, the APV model breaks up the value of operations into two components:

Voperations = Vunlevered + Vtax shield .

The free cash flows and interest tax savings are discounted separately at the unlevered cost of equity. This is more convenient to use than the corporate value model because the unlevered cost of equity can be used even when the capital structure is changing.
Also, in straight capital budgeting and the simplest application of the corporate value model all debt involved is new debt, which is issued to fund the asset additions. Hence, the debt involved all costs the same, rd, and this cost is accounted for by discounting the cash flows at the firm's WACC. However, in a merger the acquiring firm usually both assumes the existing debt of the target and issues new debt to help finance the takeover. Thus, the debt involved has different costs, and hence cannot be accounted for as a single cost in the WACC. The easiest solution is to explicitly include the interest tax shield and use the APV.
In regards to retentions, all of the cash flows from an individual project are available for use throughout the firm, since capital expenditures are explicitly accounted for. Similarly, we account for capital expenditures within the acquired firm when we calculate free cash flow. There are two equivalent ways to calculate free cash flow:
NOPAT
+ Depreciation
= Operating Cash Flow
- Gross Retentions
= Free Cash Flow
OR:
NOPAT
- Net Retentions
= Free Cash Flow
Where Net Retentions = Gross Retentions – Depreciation.

The interest tax savings are cash flows that are also available to pay interest, principal, or for other use within the firm. In the corporate valuation model (which assumed a stable capital structure) we accounted for the value of these tax savings by using a lower cost of capital--the debt component of the WACC is reduced by the factor (1-t). In the APV we discount at the higher unlevered cost of equity and take these tax savings into account explicitly.

Note that in many cases, and in this case, the corporate valuation model can be used at the horizon to calculate the horizon value. This is because in many cases the firm is at a stable capital structure by the horizon and in this case the corporate valuation model is easier to apply. So the steps are:
(1) apply corporate valuation model at horizon to get the horizon value (2) discount the free cash flows and tax shields before the horizon, along with the horizon value, at the unlevered cost of equity. This gives the value of operations. (3) subtract the current level of debt to get the current equity value.



e. Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c? What is your actual estimate of this discount rate?

Answer: As discussed above, the free cash flows, tax shields and horizon value should all be discounted at the unlevered cost of equity. This cost should be calculated based on the target’s risk, not the acquirer’s risk. Hager’s investment bankers have estimated that Lyons’ Lighting’s beta is currently 1.3. The horizon value should be calculated using Lyons’ WACC, which is based on the costs of debt and equity after any change in leverage.
To obtain the unlevered required rate of return we first need the levered required rate of return. Note that rrf = 7% and rpm = 4%. Thus, the l division's levered required rate of return on equity is:
rs(Lyons’ Lighting) = rrf + (rm - rrf)bLyons’ Lighting
= 7% + (4%)1.3 = 12.2%.

The unlevered cost of equity, based on a 20% debt ratio, cost of debt of 9%, and a levered cost of equity of 12.2% is:
rsu = wdrd + wsrsl
= 0.20(9%) + 0.80(12.2%) = 11.56%

Since Hager’s will maintain Lyons’ current capital structure of 20% debt at the horizon, the WACC to be used in the horizon value calculation can be based on the levered cost of equity calculated above. If, as we discuss in a later part to this mini-case, Lyons’ capital structure is to be changed, then a new levered cost of equity must be calculated based on this new capital structure, and the WACC calculation based on this new levered cost of equity.

WACC = wdrd(1 – T) + wsrsL
= 0.20(9%)(1 – 0.40) + 0.80(12.2%) = 10.84%







f. What is the estimated horizon, or continuing, value of the acquisition; that is, what is the estimated value of the L division's cash flows beyond 2008? What is Lyons’ value to Hager’s shareholders? Suppose another firm were evaluating Lyons’ as an acquisition candidate. Would they obtain the same value? Explain.

Answer: The 2008 cash flow is $20.7 million, and it is expected to grow at a 6 percent constant growth rate in 2009 and beyond. With a constant growth rate and stable capital structure, the corporate value model can be used to value the cash flows beyond 2008:

Horizon value =
=
= $453.3 million.

Adding the horizon value, the total cash flow stream looks like this (in millions of dollars):

2005 2006 2007 2008
Annual free cash flow $11.7 $10.5 $16.5 $ 20.7
Horizon value 453.3
Interest tax shield 2.0 2.6 2.6 2.8
Total cash flow $13.7 $13.1 $19.1 $476.8

Now, the value of Lyons’ operations is the present value of this stream, discounted at its unlevered cost of equity, 11.6%. The present value is $344.4 million.
The value of Lyons’ equity is this value of operations less its current debt of $55 million, for an equity value of $289.4million.
If another firm were valuing Lyons’, they would probably obtain an estimate different from $289.4 million. Most important, the synergies involved would likely be different, and hence the cash flow estimates would differ. Also, another potential acquirer might use different financing, or have a different tax rate, and hence estimate a different discount rate at the horizon and have different interest tax shields.







g. Assume that Lyons’ has 20 million shares outstanding. These shares are traded relatively infrequently, but the last trade, made several weeks ago, was at a price of $11 per share. Should Hager’s make an offer for Lyons’? If so, how much should it offer per share?

Answer: With a current price of $11 per share and 20 million shares outstanding, Lyons’ current market value is $11(20) = $220 million. Since Lyons’ expected value to Hager’s is $289.4 million, it appears that the merger would be beneficial to both sets of stockholders. The difference, $289.4 - $220.0 = $69.4 million, is the added value to be apportioned between the stockholders of both firms.
The offering range is from $11 per share to $289.4/20 = $14.47 per share. At $11, all of the benefit of the merger goes to Hager’s shareholders, while at $14.47, all of the value created goes to Lyons’ shareholders. If Hager’s offers more than $14.47 per share, then wealth would be transferred from Hager’s stockholders to Lyons’ stockholders.
As to the actual offering price, Hager’s should make the offer as low as possible, yet acceptable to Lyons’ shareholders. A low initial offer, say $11.50 per share, would probably be rejected and the effort wasted. Further, the offer may influence other potential suitors to consider Lyons’, and they could end up outbidding Hager’s. Conversely, a high price, say $14, passes almost all of the gain to Lyons’ stockholders, and Hager’s managers should retain as much of the synergistic value as possible for their own shareholders.
Note that this discussion assumes that Lyons’ $11 price is a "fair," equilibrium value in the absence of a merger. Since the stock trades infrequently, the $11 price may not represent a fair minimum price. Lyons’ management should make an evaluation (or hire someone to make the evaluation) of a fair price and use this information in its negotiations with Hager’s.


h. How would the analysis be different if Hager’s intended to recapitalize Lyons’ with 40% debt costing 10% at the end of four years?

Answer: The free cash flows and the unlevered cost of equity would be unchanged. If we assume that the interest payments in the first 4 years are unchanged, and the intention is to use 40 percent debt at the horizon, then the horizon levered cost of equity would increase, and the levered WACC would decrease.
New levered cost of equity = rsl = ru + (ru – rd)(d/s)
= 11.6% + (11.6% - 10%)(0.40/0.60)
= 12.6%

New WACC = wdrd(1 – t) + wsrsl
= 0.40(10%)(1 – 0.40) + 0.60(12.6%) = 9.96%

The new horizon value is based on this new WACC:

New horizon value =
=
= $554.1 million.

Assuming Hager’s will keep the same debt level for the first four years as assumed and then target a 40% debt level in the horizon, the new value of operations is the PV of the free cash flows, tax shields from before, but using this new horizon value:

New vops = $409.5 million
Less debt of $55 million leaves equity of $354.5 million. This is $65.0 million, or $3.25 per share, more than at a 20% debt level. The difference in value is due to the added interest tax shield at the higher debt level.



i. There has been considerable research undertaken to determine whether mergers really create value and, if so, how this value is shared between the parties involved. What are the results of this research?

Answer: Most researchers agree that takeovers increase the wealth of the shareholders of target firms, for otherwise they would not agree to the offer. However, there is a debate as to whether mergers benefit the acquiring firm’s shareholders. The results of these studies have shown, on average, the stock prices of target firms increase by about 30 percent in hostile tender offers, while in friendly mergers the average increase is about 20 percent. However, for both hostile and friendly deals, the stock prices of acquiring firms, on average, remain constant. Thus, one can conclude that (1) acquisitions do create value, but (2) that shareholders of target firms reap virtually all the benefits.


j. What method is used to account for mergers?

Answer: Mergers must be accounted for using purchase accounting, in which the acquired company is treated as any other capital asset purchase. The old method called “pooling accounting” has been eliminated.


k. What merger-related activities are undertaken by investment bankers?

Answer: The investment banking community is involved with mergers in a number of ways. Several of these activities are: (1) helping to arrange mergers, (2) aiding target companies in developing and implementing defensive tactics, (3) helping to value target companies, (4) helping to finance mergers, and (5) risk arbitrage--speculating in the stocks of companies that are likely takeover targets.

Hopefully, investment bankers are not giving kickbacks to company executives who give them business, or providing fraudulent analyst reports to pump up the stocks of companies they would like to do business with.




l. What is a leveraged buyout (LBO)? What are some of the advantages and disadvantages of going private?

Answer: A leveraged buyout is a situation in which a small group of investors (which usually include the firm’s managers) borrows heavily to buy all the shares of a company. Advantages to going private include administrative cost savings, increased managerial incentives, increased managerial flexibility, increased shareholder participation, and increased financial leverage. The main disadvantage of going private is not having access to the large amounts of capital available in the equity market, making it difficult to fund a firm’s projects.


m. What are the major types of divestitures? What motivates firms to divest assets?

Answer: The three primary types of divestitures are (1) the sale of an operating unit to another firm, (2) setting up the business to be divested as a separate corporation and then “spinning it off” to the divesting firm’s stockholders, and (3) outright liquidation of assets. The reasons for divestitures vary widely. Sometimes companies need cash either to finance expansion in their primary business lines or to reduce a large debt burden. Sometimes firms divest to unload losing assets that would otherwise drag the company down, or divesting may be the result of an antitrust settlement, where the government requires a breakup.




n. What are holding companies? What are their advantages and disadvantages?

Answer: Holding companies are corporations formed for the sole purpose of owning the stocks of other companies. The advantages include the ability to control a company without owning all its stocks and the ability to isolate risks. Disadvantages include the possible taxation of earnings at both the subsidiary and parent levels. Holding companies can also be easily dissolved by regulators.