Week 11 - cont. Mergers & acquisition

Question 1

4 pros of DCF/NPV analysis

Answer 1

1. Construct transparent spreadsheet of free cash flows
2. CF comes from specific forecasts and assumptions
3. Can see impact of changes in strategies
4. Valuation tied to underlying fundamentals

Question 2

4 cons of DCF/NPV analysis

Answer 2

1. CF only as good as your forecasts/assumptions
2. Might “forget something”
3. Need to forecast managerial behaviour (unless you’re in control)
   - difficult to do esp. if there is an agency problem
4. Need to estimate the discount rate using a theory (e.g. CAPM) that may be incorrect or imprecise

Question 3

Valuation by multiples procedure

Answer 3

Hope: firms in same biz have similar multiples
1. Identify firms in same biz as the firm you want to value
2. Calculate P/E ratio for comparables & take AVERAGE
3. Multiply estimated P/E by actual EPS of firm to get estimated share price

Question 4

4 pros of Valuation by multiples

Answer 4

1. Incorporates a lot of information from other valuations in a simple way
2. Embodies market consensus about discount rate and growth rate
3. Free-ride on market’s information
4. Markets essentially provide a BENCHMARK to compare your DCF valuation.

Question 5

4 cons of Valuation by multiples

Answer 5

1. Implicitly assumes all companies are alike in growth rates, cost of capital, and business composition
2. Hard time incorporating firm specific information. Particularly problematic if operating changes are going to be implemented
3. Book values can vary across firms depending on age of assets
   - DIFF. ways of calculating EBIT etc. by different companies makes valuations NON-COMPARABLE
4. If everyone uses comparables, who actually does fundamental analysis?
   - If no one does analysis, no one is doing market research and pricing the information in markets, so market is INEFFICIENT

Question 6

FREE-RIDER PROBLEM explanation of - why target prices jump up on a takeover announcement &
- why most of the gains go to the initial shareholders and not the acquirer

eg. $45 is correct share price under current management. $60 is only the correct price under NEW management

Answer 6

1. Only RAIDER can unlock the extra value in target firm
2. However the current shareholders will want to ‘free-ride’ on raider’s efforts
3. The result is that:
   - Raiders OVERPAY, reducing profits to themselves OR
   - NO RAID happens at all
4. If all shareholders are rational and homogenous the only EQUILIBRIUM is no raids
   - With heterogeneous beliefs, some raids will occur but it will be too few and raider will overpay

Question 7

Another way to get over free-rider problem in acq. is to FINANCE acq using DEBT and gain from it - > Leveraged buyout

Answer 7

You only fund a portion of the acq with your own money, remainder is borrowed.
Once company is taken over, the amount of you borrowed becomes debt of the target company, not your debt anymore.

Question 8

Asymmetric info/Mispricing explanation of
- why target prices jump up on a takeover announcement &
- why most of the gains go to the initial shareholders and not the acquirer

eg. $45 is INCORRECT under current mgmt, $60 is the CORRECT share price under current mgmt.

Answer 8

1. market is wrong about $45 share price & only the raider knows the true, correct value of share price.
2. Therefore when raider offers shares at $60, Market takes it as a SIGNAL that they were wrong about the price and readjusts from $45 to $60

If mispricing theory holds, share price should stay at correct price regardless if merger fails or suceeds.

Question 9

Merger arbitrage

Answer 9

1. When acquirer announces bid, share price rises but not by the full amount of the acquisition premium
   eg. rise from $100 to $140 but not $150
2. Trading strategy - eg. Buying target co. shares at announcement at $140 and holding until acq is COMPLETED (share price meanders up close to $150), and ACQUIRER will BUY your shares at $150 ← $10 gain
3. This is a ‘risky arbitrage opportunity’ and not actually an arbitrage b/c NOT RISK-FREE profit. Just b/c merger is announced doesn’t mean it will be successful.

Question 10

Who captures the value from a merger?

Answer 10

TARGET shareholders are the big winner.

*Relative size makes percentage division of gains {synergies} deceptive.
- Targets are typically much SMALLER than acquirers

*rmb that Combined return (size-weighted average) tends to be an AVERAGE of target’s and bidder’s return