Mergers and Acquisitions

Firm T has attracted the attention of Firm A because of its poor operating performance. Firm Abelieves that the way Firm T is managed is inefficient and that replacing the current managementteam would increase the cash flow of T by $25,000 every year up to perpetuity.Firm T has 50,000 shares outstanding and is not listed. Firm A has 250,000 shares outstandingthat are currently trading at $40/share. Firm A already owns a 1% stake in Firm T. Firm T has twoother shareholders, ABC and DEF. Both of them hold a 49.5% stake in Firm T. To change themanagement team, Firm A needs to get control of Firm T (i.e., at least 50% of shares).Firm A hires Levan Brothers, a prestigious investment bank, to get advice on the transaction.Levan Brothers estimates that the value of one share of Firm T under the current managementteam is $15 per share. They also advise Firm A to pay a premium for the acquisition of T and tooffer ABC and DEF $17 in cash for every share of Firm T. Fees charged by Levan Brothers to FirmA are $6,000. Assume that there are no taxes and markets are perfectly efficient. The appropriateannual discount rate is 10%.

1. Compute the maximum price per share that Firm A is willing to pay to acquire 99% of Firm Tvia an all-cash offer.

2. Compute ABC?s gains if he accepts the all-cash offer of $17/share.

3. ABC believes that DEF will accept the offer and tender his shares. What is the optimalstrategy for ABC: accept the offer or decline the offer? Show your answer.

4. What will happen if DEF also believes that ABC will tender his shares? What is the minimumshare price Firm A should offer to ABC and/or DEF to avoid that?

5. Compute the gains per share for Firm A if an all-cash offer to acquire 99% of Firm T is madeat a price of $20.

6. Under the assumption that ABC always believes that DEF will accept the cash offer (and viceversa), what is the likelihood that the inefficient management team is replaced some day?Explain.

Can you please provide the formula you use and every calculation steps in the answer please? Thank you.

Section M&A Decision M&A Payment and financing M&A and wealth creation M&A Processes Conclusions 1 2 3 4 5 1 M&A Decision M&A - Definition Mergers and Acquisitions (M&A) are investment projects dedicated to the acquisition of an entire firm M&A decisions are therefore investment decisions that create value for shareholders if the NPV of the investment is positive 2 M&A Decision M&A - Motivation Motivation for M&A is value creation for both, target and acquirer shareholders M&A decisions create value if the NPV of the investment is positive Acquiror shareholders: NPV>0 if Target value > Acquisition price Target shareholders: NPV>0 if Acquisition price > Target value By definition, it is impossible to observe at the same time : Target value > Acquisition price AND Target value Acquisition price Target shareholders: Acquisition price > Target value This implies that M&A transaction occur when: Target value + Synergies > Acquisition price > Target value M&A transactions create value if 1 - There are synergies 2 - The value of synergies is shared between target and acquiring shareholders 4 M&A Decision M&A - Synergies Synergy causes the value of the combined firm to exceed the sum value of the two individual firms Synergy is the additional value created (V) : ( Synergy )V VA T -(VA VT ) Where VT is the pre-merger value of the target firm, VA+T is the value of the combined entity, and VA is the pre-merger acquiring firm value Operating synergies include Revenue synergies (cross-selling, product complementarities, better competitive position) Cost synergies (spreading fixed costs, costs reduction,...) 5 M&A Decision M&A - Synergies How to value synergies Not easy ! The synergy of an acquisition can be determined from the usual DCF model: T Synergy t 1 CFt 1 r t Where the change in the cash flows ( CF ) is the incremental cash flow due to synergies implementation at date t from the merger t In practice, two business plans for the target are established : a stand alone business plan and a combined business plan Doing so allows to determine the stand alone value of the target and the value after merger (e.g. using a DCF valuation analysis) The value of synergies is then obtained by difference between the standalone value and the post-merger value 6 Section M&A Decision M&A Payment and Financing M&A and Wealth Creation M&A Processes Conclusions 1 2 3 4 5 7 M&A Payment and Financing M&A - Payment Once the decision to acquire a company has been made, the acquiror needs to choose a method of payment Payment for the target shares can be made in cash, in stocks, or both Cash offer: Target shareholders receive cash Stock offer : Target shareholders receive stocks of the new entity Mixed offer : Target shareholders receive cash and stocks of the new entity 8 M&A Payment and Financing M&A - Financing The financing depends on the method of payment Payment in cash Debt financing Acquiror raises debt and uses cash proceeds to pay for target shares Payment in stocks Equity financing Acquiror increases capital and issues new stocks . New stocks are exchanged for target shares Target shareholders become shareholders of the new entity Mixed offer Both debt and equity financing Acquiror raises debt and issues new stocks. Target shareholders receive both cash and a piece of the new entity equity value 9 Section M&A Decision M&A Payment and Financing M&A and Wealth Creation M&A Processes Conclusions 1 2 3 4 5 10 M&A Payment and Financing Value creation for shareholders The best way to measure value creation for shareholders is to compare their wealth (in cash and in stocks) before and after the transaction Target shareholders Wealth before : Target Equity Value Wealth after : Cash received + Value of shares in new entity Value creation (NPV) = Wealth after - Wealth before Acquiror shareholders Wealth before : Acquiror Equity Value Wealth after : Value of shares in new entity Value creation (NPV) = Wealth after - Wealth before Let's try to measure wealth creation for both, target and acquiror shareholders 11 M&A Payment and Financing Notation and example To determine the wealth after the transaction we need to determine the stock price of the new entity after the transaction. Notations (and figures for numeric application in blue) Target company (Firm T) NT : Number of shares = 1 million PT : Stock price of the target = $20 Acquiring firm (Firm A) NA: Number of shares = 5 million PA : Stock price of the acquiror = $10 Transaction parameters Syn: Total present value of synergies O: Offer price per target share = 25% premium over market price NI: Number of new shares issued by acquiror m: Percentage of acquisition price paid in cash 12 M&A Payment and Financing The price of the new entity Using the previous notation, we can determine the stock price of the new entity right after the announcement A Pafter A A T T N before Pbefore N before Pbefore Syn Newdebt New debt appears when acquisition price is paid in cash, and new shares are issued when acquisition price is paid in stocks Newdebt mN A N before Newshares T before O Newshares N I T (1 m) N before O A Pbefore When payment is made in stock, the number of new shares per each target share is called the exchange parity NI (1 m)O Parity T A N before Pbefore 13 M&A Payment and Financing The price of the new entity Hence we have Acquiror Equity Value A Pafter Target Equity Value Synergies Value New debt issued (if payment in cash) A A T T T N before Pbefore N before Pbefore Syn mN before O A N before T (1 m) N before O A Pbefore New shares issued (if payment in shares) This is the number of new shares NI.. If you know the number of new shares, there is not need to calculate that. Just use NI !!!!! 14 M&A Payment and Financing Wealth creation if all cash offers (m=100%) (1x20+5x10+S1x25)/5 Value creation if PV of synergies = $3M, $4M, $5M, $6M , $7M Acquiror stock price after using the formula Syn 4 5 6 7 PAafter 3 $9.6 $9.8 $10 $10.2 $10.4 Wealth creation for target shareholders (offer: 25% above market price) Syn 5 6 7 0 0 0 0 0 Stocks before $20M $20M $20M $20M $20M Total wealth $20M $20M $20M $20M $20M Cash after $25M $25M $25M $25M $25M Stock after 0 0 0 0 0 Total wealth after Stock price increases by the amount of the premium 4 Cash before Wealth increases by the amount of the premium, regardless of the amount of synergies 3 $25M $25M $25M $25M $25M Target price reaction at announcement +25% +25% +25% +25% +25% 15 M&A Payment and Financing Wealth creation if all cash offers (m=100%) (1x20+5x10+S1x25)/5 Value creation if PV of synergies = $3M, $4M, $5M, $6M , $7M Acquiror stock price after using the formula Syn 4 5 6 7 PAafter 3 $9.6 $9.8 $10 $10.2 $10.4 Wealth creation for acquirer shareholders (offer: 25% above market price) Syn 5 6 7 0 0 0 0 0 Stocks before $50M $50M $50M $50M $50M Total wealth before $50M $50M $50M $50M $50M Cash after 0 0 0 0 0 Stock after $48M $49M $50M $51M $52M Total wealth after Stock price reaction is negative when synergies lower than the premium (over payment) 4 Cash before Wealth increases when synergies exceed the premium paid 3 $48M $49M $50M $51M $52M Target price reaction at announcement -4% -2% 0% +2% +4% 16 M&A Payment and Financing Number of new stocks issued = acquisition price / Stock price of acquiror before Wealth creation if all stock offers (m=0%) = 25 / 10 = 2.5 Hence the price of the new entity will be (1x20+5x10+S)/ (5+2.5) Value creation if PV of synergies = $3M, $4M, $5M, $6M , $7M Stock price after using the formula Syn 4 5 6 7 PAafter 3 $9.73 $9.86 $10 $10.13 $10.27 Wealth creation for target shareholders (offer: 25% above market price) Syn 5 6 7 0 0 0 0 0 Stocks before ($M) 20 20 20 20 20 Total wealth ($M) 20 20 20 20 20 Cash after ($M) 0 0 0 0 0 Stock after ($M) 24.3 24.7 25.0 25.3 25.7 Total wealth after ($M) Stock price increases when synergies increase 4 Cash before ($M) Wealth increases when synergies increase because target shareholders own stocks of the new entity 3 24.3 24.7 25.0 25.3 25.7 Target price reaction at announcement +22% +23% +25% +27% +28% 17 M&A Payment and Financing Number of new stocks issued = acquisition price / Stock price of acquiror before Wealth creation if all stock offers (m=0%) = 25 / 10 = 2.5 Hence the price of the new entity will be (1x20+5x10+S)/ (5+2.5) Value creation if PV of synergies = $3M, $4M, $5M, $6M , $7M Stock price after using the formula Syn 4 5 6 7 PAafter 3 $9.73 $9.86 $10 $10.13 $10.27 Wealth creation for acquirer shareholders (offer: 25% above market price) Syn 5 6 7 0 0 0 0 0 Stocks before ($M) 50 50 50 50 50 Total wealth ($M) 50 50 50 50 50 Cash after ($M) 0 0 0 0 0 Stock after ($M) 48.7 49.3 50 50.7 51.3 Total wealth after ($M) Stock price less sensitive to synergies 4 Cash before ($M) Lower wealth destruction if no synergies, because losses are shared with target shareholders 3 48.7 49.3 50 50.7 51.3 Target price reaction at announcement -2.6% +1.3% +0% +1.3% +2.7% 18 M&A Payment and Financing NPV of the transaction for all shareholders (Alternative approach - Leads to same results !) Wealth creation (i.e. NPV) for acquiring shareholders Wealth creation (i.e. NPV) for target shareholders All cash offer (m=100%) NPV = VT+Syn-Price NPV = Price-VT All stock offer (m=0%) NPV = VT+Syn-(NI/(NA+NI))*(VT+VA+Syn) NPV = (NI/(NA+NI))*(VT+VA+Syn)-VT Where V is the equity value (VA=Bidder equity value. VT=Target equity value) The above formulas can be very easily derived from the previous slides Be careful though! These formulas assume that 100% of the target is acquired. The NPV is the total NPV for all shareholders 19 M&A Payment and Financing Example Firm Z has a current market value of $35M and is considering the acquisition of firm Y, whose current market value is $20M. Both firms are all-equity. The study made by Firm Z shows that the purchase will increase the after-tax cash flows by $600,000 in perpetuity. The appropriate discount rate for the incremental cash flow is 8%. What is the value of Firm Y to Firm Z? Firm Z is trying to decide whether to offer 25% of its own stocks or $15M cash to Firm Y shareholders. Which alternative should Z use to acquire Y? 20 M&A Payment and Financing Synthesis All cash deals: Target shareholders: NPV is equal to the premium paid (regardless of synergies) Bidder shareholders: NPV is positive if the additional benefit due to synergies exceeds the premium paid Acquiring shareholders assume all the execution risk of the deal (i.e. risk that synergies do not materialize) All share deals: Target shareholders and acquiring shareholders share the value of synergies If synergies exceed the premium, NPV will be positive for acquiring shareholder, but the magnitude of the gain will be lower compared to a cash offer If synergies lower than the premium, NPV will be negative for acquiring shareholder, but the magnitude of the loss will be lower compared to a cash offer 21 M&A Payment and Financing Empirical Evidence of Gains through M&As Target shareholders gain the most! 15 - 20% for stock-backed acquisitions 25 - 30% for cash-backed acquisitions (triggering capital gains tax) As to the buyers... In a study covering 302 deals between 1995 and 2001 worth at least US$500 million: 61% lost value over the following year The biggest losers were deals financed through shares which lost an average 8% What could explain why so many M&As fail? 22 M&A Payment and Financing Empirical Evidence of Gains through M&As ... because synergies are difficult to implement Especially when PEOPLE do not want to work together! \"DCF models\" ignore the complications of trying to efficiently and effectively blend different corporate cultures, compensation systems, promotion paths, etc Careful consideration of Organizational Behaviour (OB) issues are essential to creating value through M&A 23 Section M&A Decision M&A Payment and Financing M&A and Wealth Creation M&A Processes Conclusions 1 2 3 4 5 24 M&A Process M&As - Process In the vast majority of cases, the target is private. The process is organized by investment bankers First round (4-5 weeks) Information Memo elaborated by target company and circulated to potential bidders Bidders make a non binding offer Second round (2-3 weeks) Best bidders are given access to sensitive information about the target (Data Room) and make their \"Due diligences\" Bidders make a binding offer Last round (1- weeks) Exclusive negotiation of SPA with the best bidder Sometimes, the target is public. The process depends on the tactic adopted by the bidder Friendly vs. Aggressive takeover 25 M&A Process M&As - Hostile takeovers A takeover in which the target has no desire to be acquired and actively rebuffs the acquirer and refuses to provide any confidential information. During this process the acquirer will monitor reactions of the target firm's board and management fight any attempts to put into effect a shareholder rights plans or other defensive tactics Defense Tactics include White Knight Selling the Crown Jewels Shareholders Rights Plan (Poison Pill) Pacman 26 M&A Process M&As - Friendly acquisitions The acquisition of a target company that is willing to be taken over. Sometimes, the target will accommodate overtures and provide access to confidential information to facilitate the due diligence process. 27 Section M&A Decision M&A Payment and Financing M&A and Wealth Creation M&A Processes Conclusions 1 2 3 4 5 28 Conclusions M&As are investment projects that create value if There are synergies Synergies are shared between target and acquiring shareholders In practice, synergies are difficult to implement because M&As require that people accept to work together... ...Hence the importance human resources management in finance ! 29