Exam 1

Question 1

Value

Answer 1

The expected future free cash flows discounted at the opportunity cost of capital.
Value is not necessarily equal to price; can be though. Value is what you get, price is what you pay
Value is how much something is worth to you, but it isn’t really subjective since it is “the” expected future cash flow and “the” opportunity cost of capital
Opportunity cost of capital: the expected return on independent with similar risk

Question 2

How to calculate UFCF

Answer 2

UFCF = EBIAT + depreciation – capex – investment in NWC (ΔNWC)
When NWC is a percent of sales, ΔNWC = % (sales in yr t+1 - sales in yr t)
Also, ΔNWC = Δrequired cash + Δnon-cash working capital
And Levered free cash flows = UFCF - Interest * (1-Tax)
UFCF go to all claim holders while FCF just to equity holders

Question 3

Opportunity cost of capital

Answer 3

Need the following 2 things to determine opportunity cost of capital:
1. The return required for simply waiting (often referred to as the time value of money)
2. The return required to compensate for any exposure to risk
Many theories on relationship between risk and return; more risk rewarded by higher expected returns. Most popular theory: CAPM.
Cost of capital is a function of the investment, not the investor. Use the company you’re evaluating’s cost of capital

Question 4

CAPM

Answer 4

ri = rf + Beta * MRP
rf should be the spot rate. Can use short term (truly risk free, match life of investment) or long term (match life of company)
rm should be a diverse portfolio
Beta is the expected percent change in the excess return of a security for a 1% change in the excess return of the market portfolio. Beta of risk free = 0 bc doesn’t change w market, Beta of the market = 1
Beta = Covariance (ri, rm) / Variance (rm)
Also use a regression estimation to calculate levered Beta
We can compare only unlevered Betas, since levered Betas depend on capital structure. So we get the levered, unlever it, then relever it w new company
See the equations on the sheet to do this

Question 5

Interest Tax Shield

Answer 5

= Interest * tax
Discount it by the cost of debt when you have a dollar amount of debt; discount by the unlevered cost of capital when it is a % (I.e. constant capital structure rather than dollar amount)

Question 6

WACC Valuation Method

Answer 6

Average return the firm must pay to its investors on an after tax basis; the cost of capital for the free cash flows generated by the firm’s assets
The WACC approach is most useful when the leverage ratio is fixed over time. Tax shields are as risky as cash flows in this case (rua)
If stable D/V, then WACC stable. If not, WACC should change each year.
WACC assumes interest fully deductible and no NOLs
WACC = re *E/V + rd * D/V * (1-T)
Using WACC for Valuation:
1. Estimate UFCF in each year
2. Compute rwacc
3. Discount unlevered free cash flows at rwacc —> this is the value of the levered firm, VL
4. Subtract value of debt to get equity —> E = VL-D

Question 7

Examples:

1. True or false: We calculated our WACC two years ago. We have not changed our capital structure since then. Similarly, our equity beta has not changed. Therefore, we can use the same weighted average cost of capital as a hurdle rate to evaluate potential projects in the same line of business
2. Firm B is publicly traded but division D is not. Is it useful to know Firm B’s beta?
3. Division D has many competitors. Are the competitors’ betas relevant?

Answer 7

1. FALSE —> Tax rate may change, rf may change, Beta D may change, rm may change. WACC is annual, when evaluating, you really should change WACC every year
2. Maybe. If in same business, yes. Even if same business though, could be different capital structures. So, we compare unlevered betas to control for this and then re-lever
3. Yes, but again need unlevered

Question 8

Takeaways with WACC

Answer 8

1. Discount factor: Every asset has to be discounted by its own risk adjusted discount factor with its own beta and its own capital structure
2. Comparable firms: If no beta for asset, then identify pure players that are publicly traded, unlever each beta, average all unlevered betas as a proxy for Beta U. Then lever up using the asset’s capital structure to get to BETA E
3. Divisional hurdle ratesL: If no comparables for division D, then:
   Determine BETAU for other divisions
   Firm B’s BETAU is a weighted average of divisional BETAU’s. You can reverse engineer BETAU of division D
   Find competitors of other division Beta, get BetaU of firm and BetaU of firm less division D.
   For example, divisions A-C and we know their Beta U’s and we know the firm’s BetaU, then we can do a weighted average to get the Beta U of D
   What happens if we use Firm B’s BETAU for division D?
   Overvalue riskier divisions, undervalue less risky divisions
4. Conflicts of interest:
   If a firm is levered then:
   Conflict of interest between existing creditors and shareholders
   Shareholders maximize incumbent shareholder value not firm value
   Shareholders may dislike positive NPV projects that transfers value from them to existing creditors (underinvestment problem)

Question 9

Example: True or false: If firm A pays less than value of division D then shareholders of firm A are better off due to the acquisition as long as manager’s interests are fully aligned with those of the shareholders?

Answer 9

—> Generally true. Pay less, get more. Make sure consider the costs, make sure no negative synergies
What if firm A isn’t all equity? Shifting value from debt to equity holders—> underinvestment problem

Question 10

APV

Answer 10

WACC assumes constant debt ratio; APV is best when debt ratio is changing over time and have debt values rather than ratio. Good for LBOs as a result of that, since have debt levels
PV of interest tax shields is incorporated directly and not by adjusting discount rate
We find VL by calculating VU directly and then adding PV of ITS
For a levered firm, APV treats tax shields and other potential side effects of leverage as separate cash flows. WACC approach adjusts discount rate rather than CF
Steps:
1. Estimate UFCF (same as with WACC)
2. Discount UFCF @ rU. This gives Vu.
3. Estimate ITS for each future period: ITSt = τ rDDt-1
4. Discount ITS using rD to get PV(ITS).
5. VL = VU + PV(ITS)
6. E=VL–D

When using this on the exam, add the following 4 things:
1. PV of the ITS at rd
2. PV of the UFCF in the years valued at rua
Then we get the terminal value of the unlevered firm using the next year’s cash flow and dividing by rua - g
Do the same for levered firm with rwacc
The subtract these two values
The difference is the TV of the ITS
3. PV of the TV ITS at rd
4. PV of the TV unlevered at rua
Subtracting debt to get equity value, subtract the PV of the debt stream discounted at rd (if par bond, I.e. interest rate = discount rate, then just subtract face value)

Question 11

If creditors are paid above/below the market interest rate, what happens to the creditors, overall firm, and shareholders?

Answer 11

1. If creditors are paid above market interest rate, then:
   There is a transfer of value from shareholders to the creditors
   Each extra dollar paid to the creditor:
   A. Makes creditors $1 better off
   B. Makes overall firm $τ better off
   C. Makes shareholders $(1- τ) worse off
2. If creditors are paid below market interest rate
   Then there is a transfer of value from creditors to shareholders
   Each dollar of interest savings:
   A. Makes creditors $1 worse off
   B. Makes overall firm $τ worse off
   C. Makes shareholders $(1- τ) better off


Question 12

WACC vs APV

Answer 12

WACC:
Tax shield benefits in discount rate, D/V constant, use with typical project
APV:
Tax shield benefits added to CF - not in discount rate, need debt amounts rather than D/V, can handle side effects like interest not fully deductible or NOLs

Question 13

Multiples

Answer 13

Law of one price - 2 identical cash flow streams should have the same price
Valuation by multiples is quick and convenient, can be used as a sanity check to compare vs DCF
If differs from DCF, look for reasons why. Do DCFs of comparable companies and revisit DCF and see if we learn
First find a set of comparable companies (firms with similar cash flow characteristics: similar risk, brand position, market share, age and expected growth rates)
Next, average comparables’ multiples and multiply that by the analogous statistic for your enterprise
Steps:
Step 1 - Choose bases (measure of performance) for multiples
Step 2 - Choose comparable firms: should depend on the type of multiple
Step 3 – Average/median bases across comparable firms
Step 4 - Project bases for the valued firm
Step 5 - Value the firm

Question 14

Picking Comparable Firms for Multiples

Answer 14

We want comparable based on:
Industry, technology, and size
Capital structure
Growth potential
Operating margins
Exclude firms in the process of a major restructuring or other strategic changes
Tradeoff of too many firms (less likely to be comparable) and too little firms (we cannot average out the idiosyncratic noise)
Problem with earnings is if negative. Firms are heterogenous so P/E ratios are incomparable (accounting methods, risk characteristics and capital structures, growth opportunities, some firms may have assets that can impact P/E ratio)

Question 15

Cash flow to equity

Answer 15

Estimate cash flows to the equity of the levered firm
Dividend = UFCF - (1-T)*rDt-1 - [Dt-1 - Dt] –> dividend = UFCF in the year - after tax interest expense - reduction in debt from last year to this year
Then discount dividends at the levered cost of capital, re

High growth firms have higher multiples
Higher leverage/risk –> higher re–> lower multiples
Reinvestment: lower reinvestment (high payout) –> higher PE ratio

Question 16

EBITDA Multiple

Answer 16

Enterprise Value / EBITDA
EV = E + D - Cash (or excess cash)
Usually, book value fine proxy for value of debt
Excess cash subtracted to get core enterprise value
Adjust EBITDA for odd events such as large sale to non-recurring customer or extraordinary write-off
Immune to leverage
EBITDA is crude proxy for cash flows
EBITDA = UFCF + Taxes + CapEx + Δ NWC
EBITDA will overstate free cash flow
EBITDA is less volatile than free cash flow
CapEx and ∆NWC are discretionary & vary with business cycle
EBITDA measures earnings of existing assets, not new investments
Differences in growth opportunities is important
EBITDA multiples are useful for mature firms whose value comes mainly from existing assets
Why not just use a free cash flow multiple?
Free cash flow is volatile and sometimes negative

Question 17

Premium Paid Approach

Answer 17

Used in analyzing the “fairness” of a takeover bid.
The premium being offered is compared to the premiums paid in the most recently completed acquisitions to determine the “fairness”
Average premium (over pre-merger price) paid to target shareholders, based on 4256 takeovers, is 38

Problems:
The value of synergies will differ across acquisitions
There is a serious selection bias when only the premiums for completed transactions are considered. If anything, these are more likely to be those transactions in which the bidder has overpaid
Pre-announcement price may already be high in anticipation of a takeover

Question 18

Merger

Answer 18

A merger is a transaction that combines two or more firms into a new firm (we’ll focus on 1 acquirer and 1 target case)
Shareholders of the combining firms often remain as joint owners of the combined entity. New entity may be formed subsuming the merged firms

Question 19

Acquisition

Answer 19

An acquisition is the outright purchase of the assets or stock of one firm by another
The acquired firm becomes a subsidiary of the acquirer
The acquired firm’s shareholders generally cease to be owners

Question 20

Horizontal and Vertical

Answer 20

Horizontal:
Target and acquirer are in the same industry (Exxon and Mobile). Antitrust issues
Vertical:
Target’s industry buys from or sells to acquirer’s industry
Firms are in different stages of the production process (ex: airline company buys a travel agency, Luxottica: Italian glasses supplier enters US and buys Sunglass Hut and Raymond and force to do deal or won’t be in distribution channel)
Major benefit of vertical integration is coordination (ex: oil companies)

Question 21

Merger Wave and Why

Answer 21

A clustering in time of successful takeover bids at the industry- or economy wide level
Occur in periods of:
Economic recovery (high and sustained growth)—> have capital/cash to invest
Rapid credit expansion - low or declining interest rates
Booming stock markets —> overvalued stock —> buy another less-overvalued company
Firms tend to use stock as an acquisition currency
Industrial and technological shocks—> other companies want a piece. Merger waves cluster within industries
Regulatory changes
M&A waves end with collapse of stock markets

Why in waves?
Occurs in waves because of deal frenzy, herd behavior, envious CEOs
Information asymmetry: overvalued bidders use their stock
But target shouldn’t accept stock at these times
Uncertainty about synergies is correlated with overall uncertainty in the market
In an overvalued market, companies tend to overestimate the synergies, and hence, more willing to accept equity offers
Many of the same technological developments and economic activity that leads to expansions and bull markets also motivate the managers to reshuffle assets through mergers and acquisitions
Competition by new entrants and consolidation (ex: new technologies or deregulation make an industry shift necessary)

Question 22

Corporate Buyers (Strategics) v. Private Equity

Answer 22

PE deals don’t get the benefit of synergies, but tend to have greater efficiency and focus on exit strategies
PE backed M&A has ranged from 20-30% of total M&A

Question 23

Basic Merger Facts

Answer 23

Generally friendly (negotiated transaction between management and directors of two firms)
Requires the approval of both management teams/boards before stockholders vote
Can be structured so they are not taxable events for target stockholders unless they sell the bidder’s stock:
Taxable Event: Usually when payment is in cash, sellers of shares pay tax on capital gains
Tax-Free Event: Occurs when there is sufficient “continuity of interest” by the selling shareholders; which requires that most shareholders exchange their shares in return for the buyer’s stock. No capital gains taxes are paid
—> Taxable is cash transaction and tax-free is stock-for-stock
Term Sheet: Summary of price and method of payment; consideration paid to target shareholders can be very complex

Question 24

Hostile Merger

Answer 24

Management of target firm does not recommend bid to shareholders
Acquirer gains majority stake through:
Negotiated transaction with large shareholder
Tender offer where you bypass management and make offer directly to shareholders
Creeping tender where you use open market operations to slowly acquire controlling stake
Often done for cash so that it can happen as quick as possible, this is most liquid. Don’t deal with other bidders. But, taxable events for target shareholder since in cash
Strong incentive for the bidding firm to complete the acquisition quickly to reduce probability that a competing bidder will come along.
Generally higher premium in hostile takeover

Question 25

Tender Offers

Answer 25

Generally unfriendly. Bidder goes directly to the stockholders to buy their stock, votes, etc
Often done for cash —> taxable events for target shareholders
Process:
Start with public announcement following a 14d filing with the SEC
Filing must specify the consideration offered to the shares of the target firm, the objective of the merger (acquisition), and the timeline of events
The target management has 10 days to respond to the offer via a 14d-9 filing

Question 26

Motivation for Mergers

Answer 26

Operating Synergies, financial synergies, shady motivations, questionable motives (diversification, lower cost of debt, higher EPS)

Question 27

Operating Synergies

Answer 27

Lower costs
Economies of scale
Economies of scope (a proportionate saving gained by producing two or more distinct goods, when the cost of doing so is less than that of producing each separately; ex: soft drinks and snack foods)
Economies of vertical integration. Ex: buy your suppler
Revenue enhancement (ex: Delta and Northwest—> more customers)
Note that cost reduction synergies are easier to achieve because just getting rid of duplicates. Can fire people. For revenue synergies, need to achieve what you believe

Question 28

Financial Synergies

Answer 28

Tax shields are due to higher debt capacity (stepping up the basis to create tax shields)
Using NOLs of the target (this is different from tax shield point) —> new rule where only can carry forward NOL rather than also carry backward
Lower financial distress (lower cost of capital?)
Acquiring expertise, combining complementary resources
Buying undervalued or inefficiently operated assets
Gaining market power or entry to new markets (monopoly gains)
Limiting an increase in market power of competitors
Diversification (aka risk reduction and increasing debt capacity)
Agency problems:
Incentive conflicts
Acquisitions as a control device (a way to remove bad managers)
Empire building/managerial entrenchment, excess cash: share repurchases vs. acquisitions, and hubris: managers believe they can beat the odds
It is difficult, but important, to estimate the values of these. Always ask yourself whether it is necessary to merge to capture the efficiency/pricing gains. Are other contracting methods better than paying a premium to buy control?

Question 29

Synergy Gains: Horizontal Mergers

Answer 29

Firms producing similar products in similar markets (same industry)
Antitrust Division of the Justice Department & Federal Trade Commission worry about horizontal mergers
Monopoly pricing makes consumers worse off
Efficiency-increasing mergers make consumers better off: more output at lower prices
Horizontal mergers can yield economies of scale in R&D, purchasing, production, etc

Question 30

Synergy Gains: Vertical Mergers

Answer 30

Upstream firms buys a downstream firm, or vice versa
Are there efficiency gains from internal rather than external contracting?
Control over suppliers may reduce costs
Over integration can cause the opposite effect
Vertical mergers can yield better commitment and coordination of production process

Question 31

Synergy Gains: Congolmerate Mergers

Answer 31

Complementary mergers where you combine resources (ex: one firm has innovative product, other has great distribution and marketing)
Ex: big pharma firms (that have key drugs coming off patent) going after small firms with promising drugs
Do diversifying mergers create value?
1. Possible efficiencies in management, some centralized service, process, tech, infrastructure, purchasing, or distribution
2. Evidence: acquirers in diversifying mergers had negative abnormal returns (-2%) in the 80s. In the 90s, about 0%. Acquirers in related businesses: returns of +2% on average
Problem is diversifying mergers aren’t a good justification as you can just diversify your portfolio yourself

Question 32

Shady Motivations

Answer 32

Basic idea is transferring value from other stakeholders to the shareholders
Targets of expropriation include:
1. Government: by reducing the slice of firm value they get in taxes
Through increase leverage (LBOs) or counting one firm’s loss against other firm’s profits
2. Existing bondholders: use merger to increase leverage, reducing existing bonds’ value
With more leverage, more risky, r goes up, PV down, lower value of bond
3. Employees: use merger to force layoffs or wage reductions that existing manager is unwilling to make
4. Consumers: increased market power is good for shareholders, but bad for customers. Antitrust law set to prevent it

Question 33

Questionable Motives

Answer 33

1. Diversification:
   Absent “costly financial distress,” diversification at the corporate level doesn’t add value
   Firms have other ways to reduce the risk of financial distress (hedging, change in leverage…)
   Basic idea is that the stockholders can individually diversify, don’t need the firm to
2. Lower cost of debt
   More diversified cash flows can lower the bond yields (bond prices will go up)
   Yet this can actually hurt equity holders
   Equity holders’ default option becomes less valuable —> redistribution of value from equity to debt
   Yet, if there are costs of financial distress, lowering probability of default may also benefit equity holders
3. Higher earnings per share
   Higher EPS may mechanically result from acquisition of a firm with a lower P/E ratio
   This by itself won’t add value!

Question 34

How to See if Merger Created Value at the Time

Answer 34

Need to measure abnormal returns around the announcement
Typically, one day window to multiple weeks around the announcement
Abnormal return is spread between raw return and benchmark (S&P 500). Use CAPM
See if stock is rising because market rose or if abnormal rise because of the company, so we look at abnormal return rather than just the stock straight up
Ex: Motorola jumped 56% and Google fell 1%. Google equity beta is 1.23, S&P went up 2.2%. Based on CAPM, Google normal daily return is market * equity beta = 1.23*2.2% = 2.71%. So, abnormal return of -1 - 2.71 = -3.71%
GOOG shareholders unhappy with the merger, don’t agree with the explanation and large acquisition premium — seen with how much Motorola shares increased
Problem with this method: immediate reaction/over reaction

Question 35

Run Ups

Answer 35

We see target stock returns start going up before the announcement date then way up on announcement date
Initial takeover bids are typically preceded by substantial target stock price run-ups
Leaks, speculation based in peers being taken over results in this

Positive correlation with takeover premium because:

1. Initiation of a takeover bid results in rival bidders, bid each other up
2. Runup may be informative about the target standalone/combined value (synergies). Runups may signal the expected value of the merger and/or whether the market expect the deal will be completed
3. Target resistance (shareholders may think the value of their company is greater than the price. Managers don’t want to lose their jobs after the merger (note that this may lead to lower premium if the managers secure a position in the merged company

Question 36

Why do mergers fail?

Answer 36

Pay too much
Due diligence failures: only 30% of bidders pleased with their due diligence
Poor management of integration process
Strategy underlying the merger is inappropriate - evaluate
—> Acquirers overpay, winner’s curse, merger hubris or empire building. Once attractive target is identified, competitors join the bid
Ex: AOL and Time Warner. Problems with culture and plans didn’t align, they split up

Question 37

Typical Sale Process and Merger Negotiations

Answer 37

Private part: 1. Potential bidder solicitation, 2. Confidentiality/standstill agreements, 3. Informal bidding/LOI, 4. Final round formal bidding
Public part: 5. Signing takeover agreement and announcement, 6. Unsolicited bidding, new agreement, 7. Shareholder vote, 8. Deal closes

Merger Negotiations:
Several agreements signed at start: confidentiality (NDA), non-solicitation, stand-still, no shop/go-shop
The merger agreement (DEFM14A):
Deal terms, method of payment, stock exchange ratio, collars, fiduciary out, background of the merger
Termination agreement: breakup fee, lockup option
Shareholder agreement
Bid is announced once merger agreement is signed
Bidder and target shareholder vote:
Target shareholders always vote. Bidder shareholder vote if 20% new shares are issued in the transaction
Typically take 3-6 months to close after announcement

Question 38

Statutory Merger

Answer 38

Combination of target with the acquirer
Steps
1. Board of directors of both parties approve and sign the merger agreement
2. Target and acquirer shareholders approve the transaction in a vote (depending on the majority rule)
3. The merger closes and all but one entity legally ceases to exist and all assets and liabilities are assumed by the surviving entity
4. Appraisal rights: shareholders who opposed the merger (but lost) can demand the court to determine the fair price to be paid
If all legal entities are dissolved into a new company —> statutory consolidation (merger of equals)

Question 39

Appraisal Arbitrage

Answer 39

Investors in some high-profile mergers/buyouts have announced intention to exercise appraisal rights
Hedge funds, arbitrageurs, and other money managers are buying the stock of target companies even after a deal is announced so they have the option to exercise appraisal rights
This has contributed to more than tripling of incidents of appraisal petition filings over the past 10 years
Even for investors who buy stock in target companies following the record date for stockholder votes on mergers
Investors only need to demonstrate they didn’t vote for the merger
Fair value according to Delaware law—> wide discretion for the court to take into account all relevant factors beyond the price paid in the underlying merger, even where that price was the result of an arms-length transaction
A battle of the experts. Difference of opinions on forecasts, projections, and the counterfactual
Delaware law—> appraisal awards accrue interest at 5% above Fed Reserve discount rate compounded quarterly
Interest begins accruing at date of deal’s closing until the date that payment of judgement is made
Investors are entitled to this interest, even if the recovery is limited to a value similar to the price paid in the merger

Question 40

Acquirer Shareholders Voting Requirement

Answer 40

NYSE, AMEX, NASDAQ and most states require shareholder approval by a majority of the votes cast for acquisitions involving issuance of common stock amounting to 20% of the outstanding common stock
Relevant in M&A when the mean of payment is equity
Acquirers can avoid voting requirement by issuing less than 20% of their outstanding common stock as a consideration and paying the balance in cash, debt, or preferred stock
Why avoid voting?
Shareholders might say no
Save time: voting requires calling a special shareholder meeting; filing a proxy statement and amending it as needed

Question 41

Valuing Acquisitions

Answer 41

Evaluating a potential acquisition is similar in most respects to analyzing the NPV of any other investment project a firm may be considering
In DCF valuations, the value of potential synergies must be added to the stand-alone value of the target firm’s cash flows
Evidence shows most acquisitions don’t create value for acquiring company, but still more and larger deals happening. Need to understand sources of value and if there is a lower-cost way to achieve the proposed gains
Intrinsic Value: NPV of the future cash flows of the target under the assumption of no acquisition
Synergy Value: NPV of the future cash flows that result from the combination.
Purchase Price: How much the acquirer must pay to get the target
Market Value: The market may add a premium that incorporates the probability that the target firm is acquired. The target firm’s stock price will exceed the PV of the firm’s future cash flows if it reflects the possibility the firm may eventually be taken over at a premium (so market value is different from intrinsic value)

Question 42

Valuation

Answer 42

Value of New Co = Acquirer + Target + Synergies
Triangulate the target value:
DCF: What are the appropriate cash flows, what is the appropriate discount rate? Be careful with terminal value growth rates
APV
Multiples: comparable transaction multiples (includes some synergies) and comparable trading multiples (excludes synergies)
Estimate synergy value unless incorporated in DCF/multiples (the effects of synergy may be built into expected growth rates and cash flows)
Alternatively, target firm can be valued including performance improvements —> Vtarget + Synergies

Question 43

Three Reasons for Acqusitions

Answer 43

Undervaluation: You buy a target company because you believe the market is misplacing the company and that you can buy it for less than its fair value
Control: You buy a company that you believe is badly managed, with the intent of changing the way it is run. If you are right on the first count and can make the needed changes, value of the firm should increase under your management
Synergy: You buy a company you believe when combined with a business or resource you already own, will be able to do things that you couldn’t have done as separate entities
Synergy = Vcombined - Va - Vt
Synergy = sum of the change in cash flows discounted at the rua. Change in cash flows are the incremental expected cash flows from synergies as an add on to the exiting UFCF


Question 44

Valuing Synergies

Answer 44

Expected cash flows: use probabilities to calculate the average case scenario. May depend on the form that the synergy is expected to take. Be skeptic!
Timing: when can the synergy be reasonably expected to start affecting cash flows?
Probably should take at least 1-2 years until fully met

We discount these changes in cash flows—> change in cash flow is measuring how much extra cash flow generated bc of the synergy
The synergy can be:
Revenue enhancing: strategic gains (gains due to product mix, cross-selling products, distribution, market power)
Cost cutting: economies fo scale: declining marginal cost, gains from vertical integration or complementarities, trimming less efficient processes or labor force (management), shared fixed costs such as IT
Financial/tax: adding debt capacity and debt tax shields, using tax losses from NOLs
Difference in risk may warrant using different discount rates for valuing different type of synergies
Synergies usually do not live up to promised. Growth synergies do far better than cost synergies do in terms of living up
Some synergies are more certain (risky) than others
What form is the synergy expected to take? Reduce costs due to economies of scale, increase future growth due to greater market power, or increase debt capacity due to more stable cash flows? Should we discount cost saving and revenue growth by same rate? Need to rely on judgement and intuition
Discount rate needs to match riskiness of the synergy cash flows
Use WACC only if synergies increase debt capacity of the merged entity, as using WACC implicitly assumes additional tax shields are generated by the merger (merged firm takes on more debt to maintain same D/V after the merger)
Otherwise, use rua
If synergies are related to acquirer’s assets, use acquirer’s cost of capital
If related to target’s, use target’s cost of capital
If related to both, use combined entity’s cost of capital (weighted average to account for differences in size)
Using rua assumes no additional tax shields (merged firm doesn’t take on extra debt), however you can account for additional financial side effects when using the APV approach
—> 3 options: 1. if doesn’t increase debt capacity use APV and thats it; 2. if it does increase debt capacity: 2 options: A. use wacc; B. use APV and add extra ITS

Question 45

Premium vs Synergies

Answer 45

Acquirer gets Vtarget + synergies by paying Vtarget + premium
Acquisition is NPV>0 if premium < synergies
(Assuming Vtarget (target standalone value) is correctly priced and in a stock deal, that Vacquirer is correctly priced)
Control premium: fraction of synergies awarded to target shareholders to be able to realize the synergies
All stock deal: Vnewco=Vacquirer + Target + Synergies
All cash deal:
Vnewco = Vacquirer + Synergies - Premium =
Vacquirer + Vtarget + Synergies - Offer Price

Question 46

Value of Control

Answer 46

The value of controlling a firm derives from the fact that you believe that you or someone else would operate the firm differently (and better) from the way it is operated currently
Control can be direct (shareholding or Authority to appoint board) or indirect (veto power, casting vote)
Expected value of control = change in value from changing the way a firm is operated * the probability that this change will occur

Question 47

Mechanisms for Changing Management

Answer 47

Activist Investors: Some investors have been willing to challenge management practices at companies by offering proposals for change at annual meetings. While they have been for the most part unsuccessful at getting these proposals adopted, they have shaken up incumbent managers
Proxy contests: In proxy contests, investors who are unhappy with management try to get their nominees elected to the board of directors
Forced CEO turnover: The board of directors, in exceptional cases, can force out the CEO of a company and change top management
Hostile acquisitions: If internal processes for management change fails, stockholders have to hope that another firm or outside investor will try to take over the firm and change its management

Question 48

Control Premium

Answer 48

Control is the right to dominate the corporate decision making process and set the policies of a business enterprise
Control Premium is an amount or a percentage by which the pro rata value of a controlling interest exceeds the pro rata value of a non controlling interest
Ex: In privately negotiated transfers of controlling blocks in publicly traded companies the difference between price per share paid by the acquiring party and the price per share prevailing on the market (for the non-controlling shares) reflects the differential payoff accusing to the controlling shareholder
Higher control premium outside of the US, only 1% in US. 65% in Brazil
Private benefits from control include:
The pure pleasure of command, prestige, publicity, perks enjoyed by top executives, promoting relatives and friends to key positions, access to private information that can be utilized elsewhere, related party transaction, outright theft
Control premium not equal to synergies
Synergies requires 2 entities for its existence and is created by combining 2 entities
Control resides entirely in the target firm and doesn’t require an analysis of the acquiring firm or its valuation (ex: LBOs)

Question 49

Cash Payment

Answer 49

Cash payment—> prevalent in hostile acquisitions; quicker
Most common overall (around 80% of all deals)
More common for smaller transactions
Lead to more positive announcement effects for both target and buyer share price (stock tends to be when the stock is overvalued)
Cash offers have higher value creation in the long run—> more certain about the price (use stock when uncertain)
Cash is good as signals not overvalued and cheaper to use cash based on the peking order theory

Question 50

Securities

Answer 50

typically common stock. Prevalent in friendly mergers and when markets are more optimistic
If issue stock, shareholders may be mad because diluting; larger transactions don’t have enough cash generally so use some stock; if worried about getting synergy or want to share risk with them —> use stock
—> Use stock if your shares are overvalued, target shareholders want to share upside, less confident about synergies, target shareholders have high marginal tax rates, limited cash/debt capacity
Otherwise use cash
Exchange offers:
Transactions in which the acquirer exchanges the shares of the target company with the shares of the acquiring company
Exchange ratio: the number of shares of the buyer’s stock to be received for each share of the target firm’s stock.
Offer price / share price of the acquirer
3. Payments can also be mixed
We see that most deals are all cash then mixed then all stock. All stock was big in the 1990s

Question 51

Payment Method Choice

Answer 51

Financial flexibility (acquirer liquidity and debt capacity)—> if don’t have enough money to pay cash, then do stock. Look at ratios and make sure can pay if cash. Ratios include Debt/EBITDA, EBITDA/Int Exp, Debt/Equity
Competition from other bidders paying cash
Taxes: If pay cash —> target shareholders pay tax right away vs stock they pay when they sell the stock—> if pay the tax right away as with cash, may demand higher price
Avoid dilution/loss of control that you could get with stock
Information asymmetry (adverse selection) —> target certainty about acquirer value, acquirer certainty about target value
Uncertainty about synergies
—> when this is the case, use equity so share in the risk
Speed—> cash is quicker

Sellers typically discount equity offers more
Generally stock-based acquisitions perform poorly over the long run
Acquirer’s stock price drops relative to comparable firms which doesn’t happen when cash based
Evidence consistent with using over-valued stock to complete these acquisitions!
To sum it up, stock payment is attractive if: your (acquirer) shares are overvalued, your target’s shares are overvalued but yours are even more overvalued, target shareholders want to share upside, you are less confident about synergies, target shareholders have high marginal tax rates, and you have limited cash/debt capacity

Question 52

Example:
Consider a publicly traded all equity firm, Firm A, that operates for one period. The firm has assets in place that yield at the end of the period a cash flow of either $185, if the state of the firm is high (state H), or $85 if the state of the firm is bad (state L). Each state occurs with equal probability. Firm A identifies a target firm, T, whose value is $100. The synergies will be $15 if the merger takes place. Prior to any action, Firm A observes the true state of their firm but the target firms does not. For simplicity, we assume that the discount rate is 0%.
If firm A must use stock as a form of payment, will it be able to acquire firm T?

Answer 52

Pre-merger value of A = 1/2 (185) + 1/2 (85) = 135
Value of the combined firm = Vt + Va + Vsyn = 100 + 135 + 15 = 250
Define α = minimum exchange ratio target firm demands to break even
T will demand α = 100/250 = 0.4, as minimums exchange ratio, α = Vt / Vtotal
In state L, firm A’s shareholder value = (1-.4)(15+85+100) = 120. Note we multiply by (1-α) as α is given to firm T, so A gets the rest. A gains 35 in value here, as worth 85 in state L and now getting 120. So worth it in state L
In state H, firm A’s shareholder value = (1-.4)(15+185+100) = 180, which is now 5 less than the value alone of 185 in state H. Therefore, the firm in state H doesn’t make an offer to acquire firm T even if T is willing to accept an α of 0.4 (I.e. break even at their minimum exchange ratio)
—> Should offer stock only when acquirer is in a bad state

In state L, does A make an offer?
The uncertainty disappears now, as the target knows A will only consider making an offer if A is in state L, so combined firm V = 15+85+100 = 200. α = 100/200 = 0.5 now
So shareholder value of firm A in state L becomes (1-.5)*200 = 100, positive delta of 15 compared to 85 if no merger
The firm will complete the transaction only in state L
The decision to acquire the target is a negative signal to the market—> adverse selection leads to inefficiency

Question 53

What if firm A uses cash as a form of payment?

Answer 53

If firm A can borrow $100 and no frictions, then firm A can offer T $100 independent of the state and the inefficiency disappears
If there is a cost of raising cash (or using cash), say it is $5, then:
In state L—> firm A will make a stock offer with α = 0.5 and 15 in value (if make a cash offer, combined firm value is 85+15+100-100-5=95, delta is 10 in value < 15, so do stock)
In state H—> firm A will make a cash offer—> combined value = 185+15+100-100-5 = 195. Delta is 10 here (195-185 = 10).
There is no inefficiency with a cash offer as long as the cost due to the frictions is limited. Better firms use cash, and a stock offer is a negative solution
Note that firm A knows it is in state H or L but nobody else knows. However they can suspect based on if cash or stock, as use cash when doing well and stock when in worse state

Is Cash Always a Solution?
Sellers often know more about their firms than outside investors do
If the state of firm T is good (G), T’s value is $100 and if state is bad (B), T’s value is $50; each state is equally likely. Will a cash offer lead to a successful merger?
If firm A offers cash less than $100 but more than $50:
In state G, firm T will reject, as doing better than this offer
In state B, firm T will accept the offer, as the offer is better than what they’re doing
If firm A offers $100 in cash, T accepts
In state L, the combined firm value = [(1/2)(15+85+100)+(1/2)(15+85+50)] - 100 = 75. Delta here is 75 - 85 = -10, so A wouldn’t do it
Note this is calculated as 50% being in state G with 100 and 50% state B with 50
In state H, the combined firm value = [(1/2)(15+185+100)+(1/2)(15+185+50)]-100=175. Delta = 175 - 185 = -10
—> Target firm cannot be bought with cash; adverse selection leads to inefficiency
If firm A offers a cash offer of $50:
In state G, firm T rejects
In state B, firm T accepts
In state L, the combined firm value = (15+85+50) - 50 = 105. Delta = 105-85 = 20. Do it
In state H, combined firm value = (15+185+50)-50 = 200; delta = 15. Do it
Firm A makes a low offer and buys only the low value target firm. Cash offers can’t solve all adverse selection problems even when there are no other frictions
Problem: in a merger, good sellers can’t reap the benefits of their own high value so they stay out

Question 54

Takeaways from above example

Answer 54

1. Value of combined firm in a stock merger = Vt + Va + Vsyn
2. Value of combined firm in a cash merger = Vt+Va+Vsyn - Offer - cost of raising cash
3. If there is asymmetric information about the buyer’s value: not being able to use non-stock offers leads to inefficiency and drives the good buyers out. Cash offers increase efficiency only if the frictions are small enough
4. If there is asymmetric information about the seller’s value: cash leads to inefficiency and drives good sellers out

Question 55

Accretion and Dilution

Answer 55

Accretive: New company’s EPS > Acquirer pre-deal EPS
Dilutive: New company’s EPS < Acquirer pre-deal EPS
Stock acquisitions are typically dilutive; short run dilutive if purchase price P/E to target earnings > acquirer P/E
Cash acquisitions are typically accretive (as long as the increase in net income > cost of funding the offered price). Number of shares stays the same while earnings tend to increase
However, NPV matters, not earnings. Dilutive acquisitions can be accretive in the long run. Manage stock market’s expectations
A deal is dilutive in the short run if the price the acquirer pays for target earnings > its own PE ratio
Accretive in the short run in the acquirer pays a lower price for target earnings than its own PE ratio
See equations on page 33 of the long review notes

Question 56

Exchange Ratio

Answer 56

Without acquisition premium and wealth transfer:
Exchange ratio = Pt / Pa (generally lowest exchange ratio the target will accept)
Maximum exchange ratio for non-dilutive deal = EPSt/EPSa
Remember if exchange ratio > this, then the deal is dilutive
Higher exchange ratio means dilutive, as value of the deal is higher (I.e. you’re paying more)
If deal NPV = 0 to the buyer and buyer and the target are correctly valued, then ratio X should = (Pt + synergies/target shares)/Pa

Minimum exchange ratio for the target = value of the target / total value (Vt+Va+Vsyn)

Only use this in all stock offer

Without acquisition premium and wealth transfer: exchange ratio = Pt/Pa (generally lowest exchange ratio Target will accept)
Maximum exchange ratio for a non-dilutive deal = EPSt/EPSa
Remember if exchange ratio > this number, then dilutive

Question 57

What we should look at instead of EPS

Answer 57

The price-earnings ratio is thus a function of 1. the dividend ratio, 2. the growth rate, 3. the risk adjusted cost of equity which in its turn depends on the systematic risk of the assets (Beta ua) as well as the capital structure (higher leverage, higher Beta E and higher cost of equity re)
Beware: there are accretive bad deals and dilutive good deals
For instance, if the acquirer pays a high PE ratio because the target has a relatively high growth ratio, the long-term effect on earnings may still be accretive
NPV is more important

Question 58

Acquisition Premium

Answer 58

Acquisition premium (per share of target) = (Exchange ratio * Pa)-Pt
Acquisition premium (% of target) = (Exchange ratio * Pa - Pt)/Pt
Acquisition premium (total) = (Exchange ratio * Pa - Pt) * St

Question 59

Ex: GLM is worth $14.40 per share; SDC at $25.50. Target is GLM
There are 176.6m shares outstanding
X = 0.665
what is acquisition premium:
1. Per share of target
2. % of target
3. Total
If we assume PV of synergies = 1000; EPS of GLM = 1.5; EPS of SDC = 2.0
What would be exchange ratio if 4. no premium, 5. maximum so non-dilutive, 6. zero NPV buyer (no overvaluation)

Answer 59

1. Per share of target = .665*25.30 - 14.40 = 2.42
2. % of target = 2.42/14.4 = 16.81%
3. Total = 2.42 * 176.6M = $428.17M
4. No premium = PT/PA = 14.4/25.3 = .5692
5. Max so non-dilutive: EPSt/EPSa = 1.5/2 = 0.75
6. Zero NPV buyer (no-overvaluation) = 0.7930 (14.4+1000/176.6)/25.3
   (Pt + Syn/shares)/Pa

Question 60

Objectives of a merger agreement

Answer 60

Buyer:

1. Exclusive right to negotiate a transaction
2. Opportunity to change price (or walk away) if diligence findings are negative
3. Leave as much risk as possible with seller (thru indemnifications, pricing mechanisms)
4. Restrictions on seller’s rights after closing (compete, poach employees)
5. Minimial cost if choose not to close
6. Optimal time to get to closing (more time to secure financing)

Seller:

1. Maximum price
2. Typically, fast timing to closing
3. Minimial risk of buyer walking away
4. Limited obligations (liabilities) after close transaction

Question 61

Structure of merger

Answer 61

1. Mechanics: Determine price, structure, and adjustment mechanisms (payment form, working capital targets, debt-like items, sale type)
2. Representations & Warranties: Detail what is being bought and its condition
   Target represents key facts that are critical to the transaction & equivalent to laying out the buyer’s key assumptions in writing (e.g. financial statements are true/correct, no undisclosed liabilities, establish qualifiers of materiality and knowledge)
   Buyer also represents certain things but they are less heavily negotiated
   Used to assign risks between parties and set closing conditions
3. Schedules: List out exceptions to above representations & warranties
   As the buyer, you typically won’t like it but you need to determine whether it’s an economic issue. Becomes the basis for exclusions to any indemnities
4. Covenants: Governs conduct prior to closing and some post-closing behavior
   E.g. rules around seeking higher bids, best efforts to consummate transaction, ordinary course operations
   Again, subject to qualifiers of materiality and knowledge
   Sets guidelines for getting to closing
5. Closing Conditions: Key milestones that must be met to require both buyer and seller to close the transaction. Ex: funding conditions, third-party consents, confirmatory items
   Ties into reps & warranties; taken together they must be sufficiently true not to cause an MAE and fundamental reps must each be true
6. Indemnification: Puts in place recourse for buyer if seller breaches covenants or reps & warranties are incorrect (per above)
   Legally, removes burden of indemnified party to prove they have the right to a remedy
   Sets rules around survival (how long this lasts), payment limitations (e.g. deductible, caps), and mechanism (e.g. escrow, clawback)
7. Termination: Rules around what permits buyer or seller to terminate the transaction and drop dead dates
   Includes economic costs. Termination Fee (break fee) paid if seller walks away. Reverse Termination Fee paid if buyer walks away
8. Miscellaneous: Legal boilerplate items which can have long-term consequences (disputes, jurisdiction)

Question 62

Deal Risks

Answer 62

1. Deal-Specific:
   A. Deal completion and deal terms
   B. Competing bids
   C. Regulatory—> need to know all laws in each country that may be able to block merger (in US, all mergers above approx $60M need to be approved by government)
2. Market:
   A. Interest rates: if long term interest rates go up, present value of synergies go down, for example. Key to evaluate how long transaction will take to complete
   B. Exchange rates
   C. Overall stock market performance

Question 63

Potential Solution to Risk

Answer 63

A. Pre-closing instruments
1. Material Adverse Change Conditions
Protects acquirer from negative events occurring prior to closing but after merger agreement
Any event having a material adverse effect (MAE) on financial condition, operations, assets, liabilities, or prospects of the target
To invoke, buyer must prove the occurrence of events that substantially threaten the overall earnings potential of the target — a short term blip in earnings isn’t enough
Target negotiates to carve out/eliminate adverse effects due to general or industry specific conditions
In 2018, first time a Delaware court allowed MAE to be involved; so not very commonly invoked
IBP v Tyson Foods in 2001: short term (one quarter) drop in earnings is insufficient to invoke MAC; Delaware court

2. Collar agreements
   Floating collar agreement: involves a fixed exchange ratio if the stock price remains in a narrow range. Outside this range, sellers receive a constant value
   Fixed collar agreement: involves a fixed value if stock price remains in narrow range; outside this range the exchange ratio is fixed

B. Post-closing instruments:
1. Contingent value rights (CVR) and Earn-outs
Commitments by the buyer to pay additional cash or to issue securities contingent on achievement of financial or other performance measure targets after the deal closes
Similar to put options
Leads to positive announcement returns

Question 64

Price Protection

Answer 64

Remember that exchange ratio is the number of shares of the buyer’s stock to be received for each share of the target firm’s stock
X = offer price/acquirer stock price
Risk in exchange offers if that price can change between signing and closing
Fixed exchange stock offer and floating exchange stock offer (fixed price) are solutions

Question 65

Fixed Exchange Stock Offer

Answer 65

Fixed number of bidder shares per target share
NewCo ownership structure known at time of deal
Value of consideration not known until consummation
Depends on acquirer stock price development
Most common form of stock offer
Fixed exchange ratio generally preferred by acquirers because issuance of a fixed number of shares results in a known amount of ownership and earnings accretion or dilution
Used primarily when bidder and target in same industry
Often hedged through floors, caps, and collars. Limits upside for target shareholders and downside for bidder
Walkaway option (typically 15%)

Question 66

Example Fixed Exchange Stock Offer

Answer 66

Target has 24 million shares outstanding with shares trading at $9; acquirer shares are trading at $18.
On January 5, 2014 (“announcement date”) acquirer agrees that upon the completion of the deal (expected to be February 5, 2014) it will exchange .6667 shares of its common stock for each shares of target’s 24 million shares, totaling 16m acquirer shares.
No matter what happens to the target and acquirer share prices between now and February 5, 2014, the ratio of shares will stay fixed
On announcement date, the deal is valued at 16m shares * $18 per share = $288 million. Since there are 24 million target shares, this implies a value per target share of $288 million / 24 million = $12. That’s a 33% premium over the current trading price of $9
By February 5, 2014, target’s share price jumps to $12 because target shareholders know that they will shortly receive .6667 acquirer shares (which are worth $18 * 0.6667 = $12) for each target share.
What if, however, the value of acquirer shares drop after the announcement to $15 and remain at $15 until closing date?
Target would receive 16 million acquirer shares, and the deal value declines to 16 million * $15 = $240 million. Compare that to the original compensation the target expected of $288 million.
It should now be clear that since the exchange ratio is fixed, the number of shares the acquirer must issue is known, but the $ value of the deal is uncertain.
—> number of shares are fixed, no additional dilution risk with fixed rate

With fixed exchange offers, the price can change but the number of shares are fixed

Question 67

Floating Exchange Stock Offers

Answer 67

Also called fixed price offer
Dollar price per target share determined at time of deal
Fixed value is based on a fixed per share transaction price, each target share is converted into the number of acquirer shares which are requires to equal the predetermined per target share price upon closing
Exchange rate set over 5-day period prior to consummation pricing period
As a result, number of new acquirer shares is determined several months after the deal (merger agreement)
Ownership in NewCo unknown at time of transaction
Acquirer bears all stock price risk: floating exchange ratio is generally preferred by the target because issuance of a fixed value per share means target knows exactly how much compensation it is receiving
Less common than fixed exchange rate offers

–> Here, fixed price but floating exchange rate; number of shares can change

Question 68

Example floating exchange stock offer

Answer 68

Target has 24 million shares outstanding with shares trading at $12; acquirer shares are trading at $18
On January 5, 2014 target agrees to receive $12 from acquirer for each of target’s 24 million shares (.6667 exchange ratio) upon the completion of the deal, which is expected to be on February 5, 2014.
Just like the previous example, the deal is valued at 24m shares * $12 per share = $288 million
The difference is that this value will be fixed regardless of what happens to the target or acquirer’s share prices. Instead, the amount of acquirer shares that will have to be issued upon closing will change with changing share prices to maintain a fixed deal value.
Now what happens if acquirer shares drop after the announcement to $15 and remain at $15 until closing date?
In a floating exchange ratio transaction, it is the deal value that is fixed, while the acquirer shares are uncertain until the closing date.
Value stays the same irregardless of the share price on closing

Question 69

Floating Collar (Spread Collar)

Answer 69

Hedge against uncertainty about valuations, puts a floor and ceiling price on the transaction. Walk-away provision is the option to cancel the merger if the price falls outside specified boundaries (sudden birth)

Graph with payoff at closing on the Y axis and bidder share price at closing on the X axis
Horizontal line then sloping upwards (slope is the exchange ratio) and then horizontal line
In the narrow range when it is sloping upwards, there is a fixed exchange ratio (the slope) meaning the value can change (but same number of shares)
Outside the range, the sellers receive constant value (floating exchange ratio)

Advantages:
Hedges the sellers against downside risk (getting paid too little)
Hedges buyers against upside risk (paying too much)
Hedged against tails risk
If current price is at the same distance from each bound, then two company shareholders are protected at the same level
if the market is expected to respond negatively to the announcement, then the collar should be shifted downward to align it with the post-announcement bidder’s share price. Thus guaranteeing the expected level of protection to the bidder’s company

Question 70

Fixed Collars

Answer 70

Sloping line at exchange rate A then horizontal in the middle then sloping at exchange rate B
Y axis is payoff at closing and X is the bidder share price at closing
Fixed value if the stock price is in the narrow range
Outside the range, the exchange ratio is fixed (value changes, same number of shares but different price)
Helps prevent bidder from dilution risk as fixed exchange rate results in sellers receiving at least a pre-determined % of the merged company

Question 71

Fixed Collar Pros and Cons

Answer 71

Fixed collar is when fixed value if stock price in narrow range and outside the range you have fixed exchange rate. Slope, flat, slope
To bidder:
Pros:
1. Dilution risk minimized (pre-negotiated exchange ratio)
2. Simpler to negotiate vs floating collar offers
3. Abandon option outside of negotiated bounds
Cons:
1. Price risk management sub-optimal in presence of small relative movements of bidder vs target share prices

To Target:
Pros:
1. Achievement of a pre-negotiated interest in the bidder company
2. Abandon option outside of negotiated bounds
Cons:
Price risk management sub-optimal in pretense of small relative movements of bider vs target share prices

Question 72

Floating Collar Offers Pros and Cons

Answer 72

Floating collar is when fixed prices on either end and then fixed exchange ratio (floating price) in the middle
To Bidder:
Pros:
1. Perfect risk management of the cash value of the consideration paid
2. Abandon option outside of negotiated bounds
Cons:
sub-optiomal dilution risk management

To Target:
Pros:
1. Guaranteed cash value of the medium of exchange
2. Abandon option outside of negotiated bounds
Cons:
Uncertainty regarding pro-forma ownership structure

Question 73

Issues with Collars

Answer 73

Design needs to address the flow of information about the merger to the market
What is the right market price?
The bidder stock price at effective date of merger is usually defined as average bidder share price over a window of fixed length (typically 10 or 20 days) preceding the closing of the merger
Incentives to manipulate earnings and information
Collar deals can have termination rights
Protects the bidder from the target’s fiduciary out
If a rival bidder shows up and wins the takeover contest
US Courts have set 3% of bid value as an acceptable fee
Not triggered if shareholders vote against the takeover
Then courts only allow for compensation of bidding costs
Reverse termination fees increasingly common
Acquirer pays the target a fee if it abandons the deal
Started appearing after several PE buyers walked away from agreed transactions in 2007 and 2008

Question 74

Earn-outs and Contingent Value Rights

Answer 74

Earn-outs are pricing mechanisms that permit a portion of the purchase price to be determined after the closing of the transaction depending on factors and formulae that seller and buyer have determined at the time the initial agreement is reached
Common in high tech, pharma, private company transactions, small buyers, diversifying industries
Tied to a performance multiple (ex: EBITDA) or an event
2-5 years after the close date (average of 3 years): 20-70% of value
Positive announcement returns
Advantages: allow bidders and targets to bridge valuation disagreements, may help manage buyer’s risk, helps to retain management
Disadvantages: integration, complexity of definition, overly aggressive goals, manager’s stake

Question 75

Legal Framework

Answer 75

Antitrust laws prohibit mergers that would tend to create too much market power
State laws regulate takeover activity thru laws governing corporate charters and their bylaws
These laws were originally very pro-incumbent and mostly struck down by higher courts but have evolved thru multiple generations
We focus on Delaware bc most companies incorporated there; Delaware’s budget heavily depends on incorporation fees, legal fees, and taxes —> so professional judges that understand business, should be management friendly since management has discretion over the state of incorporation
Goal of Antitrust regulation is to prevent market dominance and abuse of market power by merged firm
Authorities in charge: Department of Justice and Federal Trade Commission
Ex: Time Warner and AT&T; government filed lawsuit to block the deal bc of antitrust concerns, judge wants it stopped if raises prices for pay TVZ consumers or threaten development of online video.

Question 76

Securities Laws in the US

Answer 76

Securities Exchange Act of 1934:
Laws designed to prevent fraud and facilitate disclosure
Cash offers were essentially unregulated, but such offers were not common
A dramatic increase in number of cash offers in the 1960s—> SEC supported to close the gap between cash and exchange offers. Pro-incumbent management concerns field legislative intervention
Williams Act of 1968 - amendment to SEA of 1934 —> requires public disclosure when a party acquires 5% or more of a target’s common stock within 10 days of crossing the 5% threshold
Specifies rules and restrictions pertaining to a tender offer
Provides early warning to firms of acquisitions of their stocks by potential acquirers
Bidders required to disclose information that is necessary to evaluate an outstanding offer
Rules regarding the tender offer process:
Tender offers must be open for at least 20 business days, if a tender is over-subscribed the bidder must accept shares on a pro-rata basis, all tendered shares get same price

Question 77

Examples

Answer 77

1. TransUnion—> even though shareholders liked the deal, one shareholder challenged deal and it got struck down in court not because of the price, but because of the process (board uninformed, merger agreement not available at board meeting, 7/9 of board members didn’t know merger was in the works, no investment bankers involved)
2. The Revlon Standard: Pantry Pride tenders Revlon at $47.50 per share; Revlon advises shareholders against the transaction and self-tenders. Pantry Pride raises price to over $53/share
   Then White Knight—> Revlon makes a deal with Forstmann at $56/share
   Pantry Price: we will top any offer they make
   Revlon agrees to $57.25 deal and lockup with Forstmann
   Outcome: Pantry Pride sues and wins, the court stops the deal from going forward.
   Legal rule: when board authorized management to negotiate a merger with Forstmann, it was a recognition that the company as for sale; once for sale the only factor that could be considered was best price for shareholders; any other interest was the breach of directors duty of loyalty. Board is entitled to choose process for achieving highest value and not required to hold an auction

Question 78

Hostile Takeovers

Answer 78

1. Bear Hug: Private letter to target CEO/board requesting private discussions/proposing transaction/timely response/threatening public disclosure (Saturday night special)
   Public disclosure of bear hug letter and target’s failure to respond
2. Building a Toehold: Share accumulation of target’s shares
3. Dawn Raid: An investor acquirers a substantial number of shares in a company first thing in the morning
4. Proxy Contest/Fight: Propose slate of directors to replace incumbent directors at the next annual meeting
5. Tender Offer: Bypassing the board, approaching target shareholders directly

Hostility = target management resists a bid, refuses to talk to the bidder and no merger agreement
Forces bidder to make a tender offer directly to shareholders
Less common in Europe where ownership is concentrated - requires target shareholders’ cooperation
Common in the 1980s but not after 1989 as spread of takeover defenses and state antitakeover statuses
About 11% of 2016 total M&A volume
Driven recently by industry consolidation and dangers of missing out; shareholder pressure to deploy cash and not buyback at high valuations; highly valued currency (acquirer’s stock), positive market reaction —> buyer stock price in 2/3 deals in 2015; buyers have greater confidence and resources
Management/board of the target opposes the deal —> if successful, target’s management and directors likely to lose their job

Question 79

Building a Toehold

Answer 79

An initial ownership stake in a firm that a corporate raider can use to initiate a takeover attempt
Once an investor has a toehold (certain threshold), they must make their intentions public by informing investors of their large stake
A public 13D filing required within 10 days of crossing 5% ownership threshold; additional Section 16 filings at and above 10% level
Purchaser tries to keep initial purchases secret to put as little upward pressure as possible on the target’s stock price. Purchases may be made thru shell corporations and partnerships to hide the true identity of the bidder
Toehold Bidding:
Many benefits from acquiring a toehold α in the target (α is the number of shares acquired)
If rival bidder wins, initial bidder makes short-term return on toehold α
Possibly as large as the target premium itself
Must purchase only 1-α shares at the offer price to save premium on toehold
Increases bidder valuation and so increases the probability of winning
Despite benefits, toehold bidding is rare—> about 10% of initial riders have a toehold, most toeholds held long term (>6 months), when toehold it is typically large (15%); in hostile takeover, 50% of bidders have toeholds
Deterrents to Toeholds:
May drive target stock price run-up, increasing total offer price
Not supported by evidence: toehold purchases increase target run-ups but not offer premiums
Loss on toehold if takeover contest fails: But target stock price typically drops back to pre-bid level after a failed bid
Could trigger target hostility:
Target holds back other deal protection, like a termination fee
Toeholds more like when termination fee is low
Conditional toehold size is larger, the greater the expected termination fee
Explains prevalence of toeholds in hostile transactions

Question 80

Tender Offers

Answer 80

Tender offers bypass target board and approach target shareholders directly
Often done for cash and faster than a merger
Offer made directly to target shareholders (scheduled TO)
Strict disclosure requirements: specifies price, consideration, conditions, length of offer
Equal treatment of tendering shareholders: pro-rata distributions, front-loaded offers not allowed; shareholders can withdraw tendered shares until offer expires
Speedy: open for ≥ 20 days, prolonged for at least 10 days if terms are changed. Highest offer price must be paid to all shareholders
Requires management response within 10 days
Can do a tender offer and then turn it into a negotiation

Free rider problem where shareholders may anticipate a successful bid coming that can raise value beyond what they are offered. But if they don’t sell, then no transaction will happen. Best off when don’t sell and others do. But if nobody sells then worse than if you had sold and enough for the tender to go thru
Free riding could prevent takeovers because you don;’t give up your share

Question 81

Proxy Fights

Answer 81

The other type of corporate control is when the shareholders vote the manager out, often resulting in proxy fights
A proxy is when the shareholder grants authority to another individual to vote his/her shares
Just a threat can be enough to facilitate change (Carl Icahn and Time Warner in 2006 - Icahn wanted to put forth his own candidates for the board to break up the firm and disperse cash. He only controlled 5% and would unlikely win proxy fight. But, the existing managers settled with Icahn and agreed to start a stock repurchase program, cut costs, and appoint two independent directors just to avoid a costly fight

Question 82

Takeover defenses pre-offer

Answer 82

1. Defensive acquisitions
2. Delay annual meeting / Eliminate shareholder right to call a special meeting
3. Golden parachutes:
   An extremely lucrative severance package that is guaranteed to a firm’s senior management in the event that the firm is taken over and the managers are let go
   Usually small relative to size of deal, so probably not much deterrence effect
   Granted by the board, no need for shareholder vote
4. Changing the state of incorporation: some states more anti-hostile than others
5. ESOPs: Employee Stock Option Plans
   Employees get equity claim in the firm but management votes the shares of the stock in the ESOP
6. Shark repellent amendments:
   A. Dual class of stock: type B get more voting rights than type A for example
   B. Supermajority vote provision
   67% or more (sometimes 80%) of votes necessary to approve control change
   However, can include board discretion on when supermajority is in effect (board out)
   Fair-price: supermajority clause can be avoided if price is high enough
   C. Staggered (classified) board: vote for board members every few years
   Bidder’s candidate would have to win a proxy fight two years in a row before bidder had a majority presence on the target board because of staggered elections
   D. Fair price and compulsory redemption
7. Poison puts/pills

Question 83

Post Offer Defense

Answer 83

1. Litigation: disclosure, anti-trust
2. White Knight
   A target company’s defense against a hostile takeover attempt, in which it looks for another, friendly company to acquire it
3. White Squire
   A variant of the white knight defense, in which a large, passive investor or firm agrees to purchase a substantial block of shares in a target with special voting rights
4. Recapitalization
   A company changes its capital structure to make itself less attractive as a target. For example, companies might choose to issue debt then use proceeds to pay a dividend or repurchase stock
5. Break-up/lock-up fees
6. Stock repurchases: e.g. greenmail
   Greenmail is buying back stock at a premium above the market price from large stockholders who may pose a threat
   Shareholders bought out (through greenmail) agree not to make further investments in the target company
7. Pacman defense: “I’ll eat you before you eat me”
   Turn around and make an offer for the bidder; buy another company to become unattractive (too large, too leveraged)
   Example: JOSB makes offer to buy MW —> MW rejects offer and then makes a counter offer to buy JOSB. Each party launched its own poison bill. JOSB buys Eddie Bauer, MW sweetens its bid and takes over JOSB
8. Corporate restructure
   Boy asset that will raise antitrust concerns if the merger is completed
   Crown jewel (scorched earth)
   Sell most attractive division or subsidiary to make target unattractive
9. Poison pill
   Main idea: warrants issued to shareholders that are worthless unless triggered by a hostile acquisition attempt. If triggered, the pills give shareholders, other than the raider, right to purchase the company’s stock at a steep discount
   The board can create and redeem the pill in a short notice and without shareholders’ approval (can be adopted by the board in 24 hours - shadow pill)
   Because target shareholders can purchase shares at less than market price, existing shareholders of the acquirer effectively subsidize their purchases, making the takeover so expensive for the acquiring shareholders that they choose to pass on the deal
   Rarely triggered
   Example: ownership flip-in plans: if the bidder acquires a threshold, shareholders (except the bidder) have the right to purchase more shares of the target firm at a discount.
   The pill effectively gives the board veto power to block deals

Question 84

Netflix Poison Pill Example

Answer 84

Netflix did this so Carl Icahn didn’t take it over and allows shareholder to buy 1/1000 of new preferred stock.
Netflix price Q4 2012 = $70 (average), exercise price = $350
# of shares outstanding = 55M
Activist ownership flip-in trigger = 20% * 55 = 11M shares
Each shareholder (other than activist) can exercise right to pay $350 and purchase shares worth $3502 = $700 (each person can buy two times the $350 - paying $350 for $700 worth of shares per the terms of the agreement)
What is the activist investor’s dilution and new share price upon exercise of rights?
# of shares purchased by each shareholder = 700/70 = 10 shares (bc price is $70)
Total # of new shares issued = 10(5580%) = 1044M = 440M
Each shareholder can buy 10 shares —> before was 44, now can get 440
New shares outstanding = 440+55 = 495M
New share price = (5570+44350)/495 = $38.88
New activist investor ownership % = 11/495 = 2.2%
New activist investor value = 11$38.88 = $427M
Loss in value = 11(70-38.88) = $342M (44%)


Successful takeovers: target stockholders can gain 10-20% or more
Unsuccessful takeover: target stockholders gain little if not eventually taken over

Question 85

Why do shareholders allow for target resistance

Answer 85

Prevents target shareholders from selling their shares
Gives management power to negotiate on behalf of dispersed shareholders
Could generate higher takeover premiums
May promote auction
Retain managerial position: above 50% target management
Agency problem or improved bargaining?
No relation between takeover defenses and premiums paid
Potentially costly if it reduces the likelihood of a takeover
Effectively prevents hostile takeovers and shifts power to management

Question 86

Benefits and costs of using defenses

Answer 86

Benefits:
Many of the defenses can force acquirers to pay a higher premium in order to get around them
Stall for more time to find a White Knight
Directly compete with bidder (LBO, leveraged recap, Pac Man)
Threaten high transaction costs (litigation, etc) as part of bargaining strategy

Costs:
Transaction costs (lawyers, investment bankers, etc)
May deter some deals that would’ve been profitable with weaker defenses but aren’t now
Entrenchment is easier
Hard/impossible to measure deals that never get tried

Question 87

Shareholder Activism

Answer 87

Activist hedge funds take small stake in underperforming or undervalued firm
Usually have a short-term investment horizon and exit strategy after stock price rises
Earlier activist campaigns targeted smaller companies where they could own a meaningful stake, but that has changed in last few years
Traditional defense mechanisms may not always be effective against activists
Number of activist campaigns on the rise recently
Large companies increasingly targeted by activists
Seen with Macy’s and Starboard: sell real estate assets; AIG-Icahn, Paulson: break up business

Question 88

Fission

Answer 88

Fission is the action of splitting two into one

Question 89

Divestitures

Answer 89

1. Asset Divestitures: Sale of firm’s assets
   Private Sale: Sell assets to a group of investors or another company
   May fetch higher price than a public offering if synergies with other company
   Buyer might have more expertise in evaluating the assets
2. Spin Off: Debut independent company created by detaching part of a parent company’s assets and operations
   Equity ownership in a subsidiary distributed to shareholders—> when Kraft broke into new Kraft and Mondelez, holders of old Kraft got 1 share of new Kraft for ever 3 Kraft shares, while old Kraft shares converted into Mondelez on a 1-for-1 basis
   No cash to the parent or divested unit
   Can take longer than a divesture since subsidiary becomes a publicly traded company
   “Splitoff” is similar to spinoff except shareholders exchange their shares for shares in NewCo, so ownership composition of NewCo and ParentCo can vary
   Advantages of spin-off:
   Provides shareholders option to either hold onto both firms or to sell one
   Managers of separated companies can be more easily evaluated
   Disadvantages of spin-off: no cash infusion to parent company
3. Carve-outs: Similar to spin offs, except that shares in the new company are not given to existing shareholders but sold in a public offering
   Sell share of new firm to the public; IPO of stock in a subsidiary (usually primary issues—> subsidiary sells shares)
   Proceeds from sale eventually go to the Parent firm via dividend to parent, repaid with proceeds from the IPO
   Typically only a portion of NewCo sold via the IPO
   In some case, firms do initial carve-out to raise cash and then spin-off the remaining shares to shareholders of parent firm
4. Privatization: The sale of a government-owned company to private investors
5. Rights offering: Basically a spin-off, but provides a cash infusion to parent firm
   Basically a spin-off, but provides cash infusion to parent firm
   Attach rights to existing shares: can buy spin-off firm shares at a discounted price
   E.g. for each share of parent firm, you get 1 right that allows you to buy a share of the spinoff at cost $X where $X is substantially < than true value $Y of each spinoff share
   Given X«

Question 90

Valuing synergies

Answer 90

DCF Method: calculate the amount COGS and SG&A saved as well as revenue. Then multiply by (1-T) to get on post-tax basis. Then discount back by rua (unless it changes debt capacity - then use WACC) to get the present value. Make sure to remember the terminal value.

Market Multiple Method: do it based off the first year —> see how much saving we would have if the synergy were fully in place in year 1. For example, say 2002 COGS were 37.90, but synergy says COGS can go down to be 65% of revenue, which would be 35.95. Then we see saving is 37.90-35.95 = 1.96, then multiply by (1-T) = 1.17 then multiply by the multiple to get the value of the saving

Question 91

Different Deal Risks (Dow)

Answer 91

Major deal risks: 1. business performance declining (MAC clause), 2. financing risk (closing conditions section of deal), 3. regulatory risk (Hell or High Water provision), 4. competing bids (no shop clause prohibiting Rohm from looking at other offers) - also Rohm must pay Dow termination fee if accepts another proposal, 5. Dow being unable to close deal on-time or at all for reason other than competing bid - reverse termination fee if this happens
Main point here is Dow should renegotiate the terms of the agreement (especially the time so they can recover from the crisis and then do the deal or Rohm find a better offer while receiving ticking fee in the meantime)