risk free rate 7% market risk premium 4% pre-merger beta 1.3 pre-merger % debt 20% pre-merger debt r d 9% Tax rate 40%

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1 Hager s Home Repair Company, a regional hardware chain, which specializes in do-ityourself materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Doug Zona, Hager s treasurer and your boss, has been asked to place a value on a potential target, Lyons Lighting, a small chain which operates in an adjacent state, and he has enlisted your help. The table below indicates Zona s estimates of Lyons earnings potential if it came under Hager s management (in millions of dollars). The interest expense listed here includes the interest (1) on Lyons existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to help finance expansion within the new L division, the code name given to the target firm. If acquired, Lyons' lighting will face a 40% tax rate. Security analysts estimate that Lyons beta is 1.3. The acquisition would not change Lyons capital structure. Zona realizes that Lyons Lighting also generates depreciation cash flows, all of which must be reinvested in the division to replace worn-out equipment. The net retentions in the table below are required reinvestment in addition to these depreciation cash flows. Zona estimates the risk-free rate to be 7 percent and the market risk premium to be 4 percent. He also estimates that free cash flows after 2013 will grow at a constant rate of 6 percent. Following are projections for sales and other items Net sales Cost of goods sold (60%) Selling/administrative expense Interest expense Debt Change in Debt Required net retentions risk free rate 7% market risk premium 4% pre-merger beta 1.3 pre-merger % debt 20% pre-merger debt pre-merger debt r d 9% Tax rate 40% $55.00 million 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 Hager Home Repair Lecture.Docx Page 1

2 has developed the following questions, which you must answer and then defend to Hager s board. a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain. Economically justifiable reasons: Synergy: Value of the whole exceeds sum of the parts. Could arise from: Operating economies Financial economies Differential management efficiency Taxes (use accumulated losses) Break-up value: Assets would be more valuable if broken up and sold to other companies. Questionable reasons for mergers: Diversification Purchase of assets at below replacement cost Acquire other firms to increase size, thus making it more difficult to be acquired b. Briefly describe the differences between a hostile merger and a friendly merger. Friendly merger: The merger is supported by the managements of both firms. Hostile merger: Target firm s management resists the merger. Acquirer must go directly to the target firm s stockholders, try to get 51% to tender their shares. Often, mergers that start out hostile end up as friendly, when offer price is raised. Page 2 Hager Home Repair Lecture.Docx

3 c. Use the data developed in the table to construct the L division s free cash flows for 2010 through Why are we identifying interest expense separately since it is not normally included in calculating free cash flows or in a capital budgeting cash flow analysis? Why are net retentions deducted in calculating the free cash flow Net sales $60.0 $90.0 $112.5 $127.5 Cost of goods sold(60%) Selling/administrative expense EBIT Taxes on EBIT(40%) NOPAT Net Retentions Free Cash Flow Interest expense Tax savings from interest $2.0 $2.6 $2.6 $2.8 d. 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? When debt levels are changing rapidly, as they do with many mergers, it is difficult to apply the corporate value model or standard capital budgeting techniques to merger valuation because the discount rate changes as the debt level changes. Instead, the APV method is easier to apply. These estimated cash flows are unlevered flows plus the tax shelter from interest payments. Because the free cash flows are unlevered equity flows, they should be discounted at the unlevered cost of equity. Similarly, the tax savings (also called tax shields) should be discounted at the unlevered cost of equity. Note that the cash flows reflect the target s business risk, not the acquiring company s. However, if the merger will affect the target s leverage and tax rate, then it will affect its financial risk. The horizon value should be calculated using the Corporate Valuation Model since capital structure is constant by then, so free cash flows should be discounted at the post-merger WACC. r s(target) = r RF + (r M - r RF ) b Target r sl (Target) = 7% + (4%)(1.3) r sl (Target) = 12.2% r su (Target) = (w d )(r d ) + (w S )(r sl ) r su (Target) = (20%)(9%) + (80.0%)(12.2%) r su (Target) = % WACC(Target) = w d (r d )(1 - T) + w s (r sl ) WACC(Target) = 1.08% % WACC(Target) = 10.84% Hager Home Repair Lecture.Docx Page 3

4 e. What is the estimated horizon, or continuing, value of the acquisition; that is, what is the estimated value of the Lyon s free cash flows beyond 2013? What is Lyons' value to Hager s shareholders? Suppose another firm were evaluating Lyons' as an acquisition candidate. Would they obtain the same value? Explain. Corporate Valuation Model Horizon Value = g = WACC = 6% 10.84% CF 0 0 CF F 1 = 1 CF F 2 = 1 CF F 3 = 1 CF = F 4 = 1 I = 10.84% Cpt NPV = V ops = PV at WACC = $345.3 million - Debt $55.00 = Equity $290.3 million Page 4 Hager Home Repair Lecture.Docx

5 Free Cash Flow to Equity Model Free Cash Flow Interest expense A-T Interest expense = Int. Exp.(1-T) $3.0 $3.9 $3.9 $4.2 Debt Change in Debt FCFE = FCF A-T Int Exp + Debt Horizon Value = g = r sl = 6% 12.2% CF 0 0 CF F 1 = 1 CF F 2 = 1 CF F 3 = 1 CF = F 4 = 1 I = 12.2% Cpt NPV = Value of Equity = $287.9 million Hager Home Repair Lecture.Docx Page 5

6 Adjusted Present Value Model Free Cash Flow Tax Shield from interest $2.0 $2.6 $2.6 $2.8 Horizon Value (FCF) = r su = g = 11.56% 6% Horizon Value (Tax Shield) = r su = g = 11.56% 6% CF 0 0 CF F 1 = 1 CF F 2 = 1 CF F 3 = 1 CF = F 4 = 1 I = 11.56% Cpt NPV = CF 0 0 CF F 1 = 1 CF F 2 = 2 CF = 56.2 F 3 = 1 I = 11.56% Cpt NPV = 42.0 V ops = PV at r su = = million - Debt $55.00 = Equity $285.9 million Page 6 Hager Home Repair Lecture.Docx

7 Would another potential acquirer obtain the same value? No. The cash flow estimates would be different, both due to forecasting inaccuracies and to differential synergies. Further, a different beta estimate, financing mix, or tax rate would change the discount rate. f. Assume that Lyons' has 20 million shares outstanding. These shares are traded relatively infrequently, but the last trade, made several weeks ago, was at a price of $11 per share. Should Hager s make an offer for Lyons'? If so, how much should it offer per share? Estimated Value of Target = $290.3 This is from the Corporate Valuation Model Target's Current Value = $ million shares($11/share) Merger Premium = $70.3 Presumably, the target s value is increased by $70.3 million due to merger synergies, although realizing such synergies has been problematic in many mergers. The offer could range from $11 to $290.3/20 = $14.52 per share. At $11, all merger benefits would go to the acquiring firm s shareholders. At $14.52, all value added would go to the target firm s shareholders. Hager Home Repair Lecture.Docx Page 7

8 g. How would the analysis be different if Hager's intended to recapitalize Lyons' with 40 percent debt costing 10% at the end of 4 years? The free cash flows and the unlevered cost of equity would be unchanged. If we assume that the interest payments in the first 4 years are unchanged, and the intention is to use 40 percent debt at the horizon, then the horizon levered cost of equity would increase, and the levered WACC would decrease. new % debt = 40% new r d = 10% New levered cost of equity: r sl = r U + ( r U - r D )D/S r sl = 11.56% + (11.56% - 10%)( ) r sl = 12.60% New WACC: WACC(Target) = w d (r d )(1 - T) + w s (r s ) WACC(Target) = 2.40% % WACC(Target) = 9.96% New Horizon Value: Horizon Value = g = WACC = 6% 9.96% Since the free cash flows and the intermediate interest payments don't change, all we need to do is look at the present value of the difference in the horizon values. New Horizon Value = $554.1million Old Horizon Value = Difference PV at r su = $453.3million million $65.04million Lyons' Lighting is worth $65.04 million more to Hager's at 40% debt than at 20% debt. The difference is the added benefit of a larger tax shield. This amounts to $3.25 per share difference in maximum purchase price. Page 8 Hager Home Repair Lecture.Docx

9 h. 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? According to empirical evidence, acquisitions do create value as a result of economies of scale, other synergies, and/or better management. Shareholders of target firms reap most of the benefits, that is, the final price is close to full value. Target management can always say no. Competing bidders often push up prices. What method is used to account for mergers? Pooling of interests has been eliminated. Only purchase accounting may be used. Purchase: The assets of the acquired firm are written up to reflect purchase price if it is greater than the net asset value. Goodwill is often created, which appears as an asset on the balance sheet. Common equity account is increased to balance assets and claims. Goodwill is not amortized or expensed over time. Instead, it is subject to an "impairment" test. If goodwill drops in market value, then a charge for this reduction must be taken. Otherwise, no expense for goodwill is recorded. Note: goodwill is still amortized for Federal income tax purposes. j. What merger-related activities are undertaken by investment bankers? Identifying targets Arranging mergers Developing defensive tactics Establishing a fair value Financing mergers Arbitrage operations Hopefully: not paying kickbacks to CEOs for business, and not providing fraudulent analyst reports to pump up stock prices Hager Home Repair Lecture.Docx Page 9

10 k. What is a leveraged buyout (LBO)? What are some of the advantages and disadvantages of going private? In an LBO, a small group of investors, normally including management, buys all of the publicly held stock, and hence takes the firm private. The purchase is often financed with debt. After operating privately for a number of years, investors take the firm public to cash out. Advantages: Administrative cost savings Increased managerial incentives Increased managerial flexibility Increased shareholder participation Disadvantages: Limited access to equity capital No way to capture return on investment l. What are the major types of divestitures? What motivates firms to divest assets? Sale of an entire subsidiary to another firm. Spinning off a corporate subsidiary by giving the stock to existing shareholders. Carving out a corporate subsidiary by selling a minority interest. Outright liquidation of assets. A firm divests assets: Because the subsidiary worth more to buyer than when operated by current owner. To settle antitrust issues. Because subsidiary s value increased if it operates independently. To change strategic direction. To shed money losers. To get needed cash when distressed. m. What are holding companies? What are their advantages and disadvantages? A holding company is a corporation formed for the sole purpose of owning the stocks of other companies. In a typical holding company, the subsidiary companies issue their own debt, but their equity is held by the holding company, which, in turn, sells stock to individual investors. Advantages: Control with fractional ownership. Isolation of risks. Disadvantages: Partial multiple taxation. Ease of enforced dissolution. Page 10 Hager Home Repair Lecture.Docx

Web Extension: Comparison of Alternative Valuation Models

19878_26W_p001-009.qxd 3/14/06 3:08 PM Page 1 C H A P T E R 26 Web Extension: Comparison of Alternative Valuation Models We described the APV model in Chapter 26 because it is easier to implement when