Ch 25 Mini Case

3/12/2003

Chapter 25. Mini Case for Mergers, LBOs, Divestitures, and Holding Companies
Hagers Home Repair Company, a regional hardware chain, which specializes in do-it-yourself materials
and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for
the excess funds is an acquisition. Doug Zona, Hagers 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 Zonas estimates of Lyons earnings potential if it came under Hagers
management (in millions of dollars). The interest expense listed here includes the interest (1) on Lyons
existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to
help finance expansion within the new L division, the code name given to the target firm. If acquired,
Lyons' lighting will face a 40% tax rate.

Security analysts estimate that Lyons beta is 1.3. The acquisition would not change Lyons capital structure.
Zona realizes that Lyons Lighting also generates depreciation cash flows, all of which must be reinvested in
the division to replace worn-out equipment. The net retentions in the table below are required reinvestment
in addition to these depreciation cash flows.
Zona estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. He also
estimates that free cash flows after 2007 will grow at a constant rate of 6 percent. Following are projections
for sales and other items.
2004
Net sales
Cost of goods sold (60%)
Selling/administrative expense
Interest expense
Required net retentions
risk free rate
market risk premium
pre-merger beta
pre-merger % debt
pre-merger debt
pre-merger debt rd
Tax rate

60.0
36.0
4.5
5.0
0.0
7%
4%
1.3
20%
$
55.00
9%
40%

2005
90.0
54.0
6.0
6.5
7.5

2006
112.5
67.5
7.5
6.5
6.0

2007
127.5
76.5
9.0
7.0
4.5

million

Hagers management is new to the merger game, so Zona has been asked to answer some basic questions
about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the
following questions, which you must answer and then defend to Hagers 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 firms management resists the merger.
Acquirer must go directly to the target firms stockholders, try to get 51% to tender their shares.
Often, mergers that start out hostile end up as friendly, when offer price is raised.

c.

Use the data developed in the table to construct the L divisions free cash flows for 2004 through 2007.
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
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

2004
2005
2006
2007
60.0 $
90.0 $
112.5 $ 127.5
36.0
54.0
67.5
76.5
4.5
6.0
7.5
9.0
19.5
30.0
37.5
42.0
7.8
12.0
15.0
16.8
11.7
18.0
22.5
25.2
0.0
7.5
6.0
4.5
11.7
10.5
16.5
20.7
5.0
2.0 $

6.5
2.6 $

6.5
2.6 $

7.0
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 targets business risk, not the acquiring companys. However, if the merger will affect
the targets 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.
rs(Target) = rRF + (rM - rRF) bTarget
rsL(Target) =
7%
rsL(Target) =
12.2%
rsU(Target) =
rsU(Target) =
rsU(Target) =

4%

wd

rd

20%
11.560%

9%

rL
12.2%

ws(rs)

+
+

1.08%
10.84%

1.3

wS
80.0%

wd(rd)(1 - T)

WACC(Target) =
WACC(Target) =
WACC(Target) =

e.

9.76%

What is the estimated horizon, or continuing, value of the acquisition; that is, what is the estimated value
of the L division's free cash flows beyond 2007? What is Lyons' value to Hagers shareholders? Suppose
another firm were evaluating Lyons' as an acquisition candidate. Would they obtain the same value?
Explain.

Horizon Value =

Beta =
Tax Rate =
WACC =
g=

(2007 Free Cash Flow)(1+g)

Horizon Value = $

WACC - g
453.3 million
2004

Free Cash Flow

Horizon Value
Interest tax shield
Total
Vops = PV at rsU =
- Debt
= Equity

1.3
40%
10.84%
6%

$
$
$
$
$
$

2005

11.7 $
2.0 $
13.7

2006

10.5 $
2.6 $
13.1 $

2007

16.5 $
$
2.6 $

20.7
453.3
2.8

19.1

476.8

344.4 million
55.00
289.4 million

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.
Note: Change the shaded cells above ( beta or tax rate ) to see the change in value

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 Hagers make an
offer for Lyons'? If so, how much should it offer per share?
Estimated Value of Target = $
Target's Current Value = $
Merger Premium = $

289.4
220.0
69.4

20 million shares x $11/share

Presumably, the targets value is increased by $69.4 million due to merger synergies, although realizing
such synergies has been problematic in many mergers.
The offer could range from $11 to $289.4/20 = $14.47 per share. At $11, all merger benefits would go to the
acquiring firms shareholders. At $14.47, all value added would go to the target firms shareholders.

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
new rd

40%
10%

New levered cost of equity:

rsL
rU
=
rsL
=
11.56%
rsL
=
12.60%
New WACC:
WACC(Target) =
WACC(Target) =
WACC(Target) =

+
+

rU

11.56%

wd(rd)(1 - T)

+
+

2.40%
9.96%

rD

) D/S
10% 0.66666667

ws(rs)
7.56%

New Horizon Value

(2007 Free Cash Flow)(1+g)
Horizon Value =
WACC - g
FCF2007=
g=

20.7
6%

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 =
Old Horizon Value =
Difference
PV at rsU =

$
$
$

554.1
453.3
100.74
65.04

million
million
million
million

Lyons' Lighting is worth

more to Hager's at 40% debt
$
65.04 million
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.
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.
i.

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.

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.
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 subsidiarys 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.