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Chapter 25

Mergers, LBOs, Divestitures, and Holding Companies

ANSWERS TO END-OF-CHAPTER QUESTIONS

 

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Questions

(25-1) Define each of the following terms:

a. Synergy; merger

b. Horizontal merger; vertical merger; congeneric merger; conglomerate merger

c. Friendly merger; hostile merger; defensive merger; tender offer; target company; breakup value; acquiring company

d. Operating merger; financial merger

e. Adjusted present value (APV) model

f. Free cash flow to equity

g. Purchase accounting

h. White knight; proxy fight

i. Joint venture; corporate alliance

j. Divestiture; spin-off; leveraged buyout (LBO)

k. Holding company; operating company; parent company

l. Arbitrage; risk arbitrage

(25-2) Four economic classifications of mergers are (1) horizontal, (2) vertical, (3) conglomerate, and (4) congeneric. Explain the significance of these terms in merger analysis with regard to (a) the likelihood of governmental intervention and (b) possibilities for operating synergy.

(25-3) Firm A wants to acquire Firm B. Firm B’s management agrees that the merger is a good idea. Might a tender offer be used?

(25-4) Distinguish between operating mergers and financial mergers.

(25-5) Distinguish between the APV, FCFE, and corporate valuation models.

Self-Test Problem Solution Appears in Appendix A

(ST–1)

Valuation

Red Valley Breweries is considering an acquisition of Flagg Markets. Flagg currently has a cost of equity of 10%; 25% of its financing is in the form of 6% debt, and the rest is in common equity. Its federal-plus-state tax rate is 40%. After the acquisition, Red Valley expects Flagg to have the following FCFs and interest payments for the next 3 years (in millions):

Year 1                    Year 2                   Year 3

FCF                                        $10.00                   $20.00                   $25.00

Interest expense             28.00                     24.00                     20.28

After this, the free cash flows are expected to grow at a constant rate of 5%, and the capital structure will stabilize at 35% debt with an interest rate of 7%.

a. What is Flagg’s unlevered cost of equity? What are its levered cost of equity and cost of capital for the post-horizon period?

b. Using the adjusted present value approach, what is Flagg’s value of operations to Red Valley?

Problems Answers Appear in Appendix B

The following information is required to work Problems 21-1 through 21-4.

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1 million shares outstanding and a target capital structure consisting of 30% debt. Vandell’s debt interest rate is 8%. Assume that the risk-free rate of interest is 5% and the market risk premium is 6%. Both Vandell and Hastings face a 40% tax rate.

EASYPROBLEM1

(25-1)

Valuation

Vandell’s free cash flow (FCF0) is $2 million per year and is expected to grow at a constant rate of 5% a year; its beta is 1.4. What is the value of Vandell’s operations? If Vandell has $10.82 million in debt, what is the current value of Vandell’s stock? (Hint: Use the corporate valuation model from Chapter 13.)

INTERMEDIATEPROBLEMS2–3

(25-2)

Merger Valuation

Hastings estimates that if it acquires Vandell, interest payments will be $1,500,000 per year for 3 years, after which the current target capital structure of 30% debt will be maintained. Interest in the fourth year will be $1.472 million, after which interest and the tax shield will grow at 5%. Synergies will cause the free cash flows to be $2.5 million, $2.9 million, $3.4 million, and $3.57 million in Years 1 through 4, respectively, after which the free cash flows will grow at a 5% rate. What is the unlevered value of Vandell, and what is the value of its tax shields? What is the per share value of Vandell to Hastings Corporation? Assume that Vandell now has $10.82 million in debt.

(25-3)

Merger Bid

On the basis of your answers to Problems 21-1 and 21-2, indicate the range of possible prices that Hastings could bid for each share of Vandell common stock in an acquisition.

CHALLENGINGPROBLEMS4–6

(25-4) Merger Valuation with

Change in Capital Structure

Assuming the same information as for Problem 21-2, suppose Hastings will increase Vandell’s level of debt at the end of Year 3 to $30.6 million so that the target capital structure is now 45% debt. Assume that with this higher level of debt the interest rate would be 8.5%, and assume that interest payments in Year 4 are based on the new debt level from the end of Year 3 and a new interest rate. Again, free cash flows and tax shields are projected to grow at 5% after Year 4. What are the values of the unlevered firm and the tax shield, and what is the maximum price that Hastings would bid for Vandell now?

(25-5) Merger Analysis

Marston Marble Corporation is considering a merger with the Conroy Concrete Company. Conroy is a publicly traded company, and its beta is 1.30. Conroy has been barely profitable, so it has paid an average of only 20% in taxes during the last several years. In addition, it uses little debt; its target ratio is just 25%, with the cost of debt 9%. If the acquisition were made, Marston would operate Conroy as a separate, wholly owned subsidiary. Marston would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35%. Marston also would increase the debt capitalization in the Conroy subsidiary to wd= 40%, for a total of $22.27 million in debt by the end of Year 4, and pay 9.5% on the debt. Marston’s acquisition department estimates that Conroy, if acquired, would generate the following free cash flows and interest expenses (in millions of dollars) in Years 1–5:

Year                       Free Cash Flows               Interest Expense

1                              $1.30                                                     $1.2

2                              1.50                                                        1.7

3                              1.75                                                        2.8

4                              2.00                                                        2.1

5                              2.12                                                        ?

In Year 5, Conroy’s interest expense would be based on its beginning-of-year (that is, the end-of-Year-4) debt, and in subsequent years both interest expense and free cash flows are projected to grow at a rate of 6%. These cash flows include all acquisition effects. Marston’s cost of equity is 10.5%, its beta is 1.0, and its cost of debt is 9.5%. The risk-free rate is 6%, and the market risk premium is 4.5%.

a. What is the value of Conroy’s unlevered operations, and what is the value of Conroy’s tax shields under the proposed merger and financing arrangements?

b. What is the dollar value of Conroy’s operations? If Conroy has $10 million in debt outstanding, how much would Marston be willing to pay for Conroy?

(25-6)

Merger Valuation with

Change in Capital Structure

VolWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Bulldog Cable Company (BCC), a regional cable company. VolWorld’s analysts project the following post-merger data for BCC (in thou-sands of dollars, with a year end of December 31):

2010       2011       2012      2013      2014      2015

Net sales                                                                             $450       $518       $555       $600       $643

Selling and administrative expense                          45           53           60           68           73

Interest                                                                                40           45           47           52           54

Total net operating capital                           $800       850         930         1,005     1,075     1,150

Tax rate after merger: 35%

Cost of goods sold as a percent of sales: 65%

BCC’s pre-merger beta: 1.40

Risk-free rate: 6%

Market risk premium: 4%

Terminal growth rate of free cash flows: 7%

If the acquisition is made, it will occur on January 1, 2011. All cash flows shown in the income statements are assumed to occur at the end of the year. BCC currently has a capital structure of 40% debt, which costs 10%, but over the next 4 years Vol-World would increase that to 50%, and the target capital structure would be reached by the start of 2015. BCC, if independent, would pay taxes at 20%, but its income would be taxed at 35% if it were consolidated. BCC’s current market-determined beta is 1.4. The cost of goods sold is expected to be 65% of sales.

a. What is the unlevered cost of equity for BCC?

b. What are the free cash flows and interest tax shields for the first 5 years?

c. What is BCC’s horizon value of interest tax shields and unlevered horizon value?

d. What is the value of BCC’s equity to VolWorld’s shareholders if BCC has $300,000 in debt outstanding now?

SPREADSHEETPROBLEM

(25-7)

Build a Model: Merger Analysis

Start with the partial model in the fileCh21 P07 Build a Model.xlson the textbook’s Web site. Wansley Portal Inc., a large Internet service provider, is evaluating the possible acquisition of Alabama Connections Company (ACC), a regional Internet service provider. Wansley’s analysts project the following post-merger data for ACC (in thousands of dollars):

2011       2012       2013       2014       2015

Net sales                                                             $500       $600       $700       $760       $806

Selling and administrative expense          60           70           80           90           96

Interest                                                                30           40           45           60           74

If the acquisition is made, it will occur on January 1, 2011. All cash flows shown in the income statements are assumed to occur at the end of the year. ACC currently has a capital structure of 30% debt, which costs 9%, but Wansley would increase that over time to 40%, costing 10%, if the acquisition were made. ACC, if independent, would pay taxes at 30%, but its income would be taxed at 35% if it were con-solidated. ACC’s current market-determined beta is 1.4. The cost of goods sold, which includes depreciation, is expected to be 65% of sales, but it could vary some-what. Required gross investment in operating capital is approximately equal to the depreciation charged, so there will be no investment in net operating capital. The risk-free rate is 7%, and the market risk premium is 6.5%. Wansley currently has $400,000 in debt outstanding.

a. What is the unlevered cost of equity?

b. What are the horizon value of the tax shields and the horizon value of the unlevered operations? What are the value of ACC’s operations and the value of ACC’s equity to Wansley’s shareholders?

Mini Case

Hager’s Home Repair Company, a regional hardware chain that 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 (LL), a chain that operates in several adjacent states, and he has enlisted your help.

The table below indicates Zona’s estimates of LL’s earnings potential if it came under Ha-ger’s management (in millions of dollars). The interest expense listed here includes the interest

(1) on LL’s 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, LL will face a 40% tax rate.

Security analysts estimate LL’s beta to be 1.3. The acquisition would not change Lyons’s capital structure, which is 20% debt. Zona realizes that Lyons Lighting’s business plan also requires certain levels of operating capital and that the annual investment could be significant. The required levels of total net operating capital are listed in the table. Zona estimates the risk-free rate to be 7% and the market risk premium to be 4%. He also estimates that free cash flows after 2015 will grow at a constant rate of 6%. Following are projections for sales and other items.

2010       2011       2012       2013       2014       2015

Net sales                                                                             $60.00   $90.00   $112.50 $127.50 $139.70

Cost of goods sold (60%)                                              36.00     54.00     67.50     76.50     83.80

Selling/administrative expense                                                 4.50        6.00        7.50        9.00        11.00

Interest expense                                                             5.00        6.50        6.50        7.00        8.16

Total net operating capital                           $150       150         157.50   163.50   168         173.00

Hager’s 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 re-placement 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.

b. Briefly describe the differences between a hostile merger and a friendly merger.

c. What are the steps in valuing a merger?

d. Use the data developed in the table to construct the L division’s free cash flows for 2011 through 2015. Why are we identifying interest expense separately when it is not normally included in calculating free cash flows or in a capital budgeting cash flow analysis? Why is investment in net operating capital included when calculating the free cash flow?

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?

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 2015? What is LL’s value to Hager’s shareholders? Suppose another firm were evaluating LL as an acquisition candidate. Would it obtain the same value? Explain.

g. Assume that LL 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 Lighting? If so, how much should it offer per share?

h. How would the analysis be different if Hager’s intended to recapitalize LL with 40% debt costing 10% at the end of 4 years? This amounts to $221.6 million in debt as of the end of 2014.

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?

j. What method is used to account for mergers?

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

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

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

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