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Financial Management

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Financial Management ­ MGT201
VU
Lesson 43
MERGERS AND ACQUISITIONS
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topic:
·  Mergers & Acquisitions (M&A)
Mergers & Acquisitions (M&A):
·  The buying & selling of entire firms or divisions of firms is a specialized art in finance.
·  Why firms Merge?
­  Diversification:
·  Reduce Risk and Stabilize Earnings, attain Economies of Scale
·  Achieve Long Term Strategic Goals, Gain Larger Market Share and Quick
Growth in size,
­  Improving Financials: quick way to improve the Balance Sheet and Cash Flows
­  Find Cash: if another firm has large cash flows, cash reserves or liquid assets
·  Cherry Picking: It means when Market Value of another similar firm is less
than cost of replacing your own assets it might be better to buy another firm
·  Asset Stripping: separate out the non-profitable and sell its assets individually
to generate cash and restore profitability
­  Agency Cost: Desire of Managers for Prestige, Power, and Salary sometimes at expense
of Shareholders (Owners)
·  Winning Management Control (exercise influence on Board).  Manager
Salaries Rise (larger firm, Agency Costs). Fear of Losing Job if Taken Over by
Rival Firm.
·  How do you pay for (or finance) buying a Firm?
­  Cash, Stock or Shares, Bank Borrowing or Debt (LBO's) or Combination
·  "Merger" When 2 or more Firms combine to form 1 Firm.
·  Benefit of Merger Synergy:
2+2 = 5!
It means value of a combined firm after merger is more than the firms' value individually before
the merger
·  2 Broad Categories of Mergers:
·  Pure Financial Merger - Operations remain independent
·  Operating Merger - Operations are Integrated & Changed & Synergies
Expected
·  4 Specific Types of Mergers:
·  Horizontal Merger: merger of 2 competitors - can lead to Monopoly
·  Vertical Merger: merger of a supplier with a buyer
·  Co generic Merger: merger of firms in same industry
·  Conglomerate Merger: merger of firms in unrelated industries
·  "Acquisition": Most common form of Merger.
·  When a Firm buys another Firm. This acquisition Can be "Hostile" Raid or  "Friendly"
·  The firm that acquires the other firm is known as acquirer firm but the firm which is acquired is
known as Target firm
·  "Divestiture" = Reverse Merger. Benefit of Efficient Reallocation of Resources:
5 - 1 = 5!
It means by selling an inefficient or unproductive unit of the company you can have more value
as it saves costs
·  "Sell off" - Sale (transfer Ownership) of a Division of a Firm
·  "Spin off" - transfer Management Control of a Division of a Firm
·  "Liquidation" - Sale of assets to pay off Shareholders
Merger Issues & Regulations:
·  Monopoly (Concentration of Power and Market Share)
­  Horizontal or Vertical Merger of 2 giants.
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Financial Management ­ MGT201
VU
­  Laws vary from country to country i.e. Anti-Trust Laws
·
Hostile Acquisitions (or Takeovers) by Corporate Raiders
­  2 Basic Ways of Hostile Takeovers:
·  Canvassing general public shareholders for their Proxy Votes
·  Limited-time Share Tender Offer by Raider at share price above the market
Corporate raiders urge the shareholders to buy their shares.
­  How Target Firm can Respond to Hostile Raid
·  Poison Pill ­ Target Firm takes on excessive short-term debt to appear
unhealthy. Because of high liabilities their balance sheet becomes unattractive.
·  White Knight ­ a wealthy friendly investor who protects the Target Firm by
making higher counter-tender offer against the corporate Raider.
·  Fight Back: Target Firm makes counter-tender offer to shareholders
·  Be Acquired (if Raider is offering much higher value than Firm is worth)
­  Target Firm need protection under law ­ Shareholders might lose ownership and
Employees might lose their jobs.
Leveraged Buy-Outs (LBO's):
·  Mechanism of Leveraged Buy-Outs (LBO's) using Debt Financing: Acquiring Firm borrows a
lot of money (from Debt Investors) to buy the shares of another publicly traded Target Firm.
The Public Firm thus becomes "Privatized" in the hands of fewer shareholders and it also means
less administrative costs. It then sells assets (Asset Stripping) of the Target to make immediate
interest payments. If Firm runs into difficulty, then can raise more money by selling its own
Junk Bonds. After Restructuring, Cost Cutting, and Down-Sizing, the firm (now financially
stronger) again goes Public giving opportunity for its stakeholders and deal-makers and
Investment Bank Advisers to recover their Investment and en cash Capital Gains.
·  Possible Advantages of LBO: Debt increases Tax Shield Savings, Leverage can improve ROE,
and forces cost cutting measures by Management
·  Management Buyouts & "Going Private": A type of LBO. Management buys all or most of
publicly held shares of their own firm and effectively converts public firm into a privately held
one.
Mergers - Good or Bad?
·  Impact of Mergers on Market, Shareholder, & Employees
­  Temporary Increase in Stock Price because of competing Tender Offers by Buyer.
Wrong signals distort market prices.
­  Target Firms forced to take Drastic Measures to defend themselves i.e. Poison Pills.
Waste of Firm's resources and Value.
­  Mergers often followed by Cost Cutting, Streamlining which can improve Operational
Efficiency & Add Synergy. BUT, Down-sizing of Employees or Job Cuts can lead to
serious social problem
Numerical Valuation of a Target Firm Merger Analysis & Valuation:
·  2 Basic Approaches to Mergers Analysis and Valuation
­  Discounted Cash Flows (DCF)
­  Market Multiple Analysis (MMA)
·  Discounted Cash Flows (DCF) uses NPV: We used in Capital Budgeting
o  Estimate Post Merger Performa (Forecasted) Net After-Tax Incremental Cash Flows
(CF's) of Target Firm for 5 Yrs or more. Account for Post ­ Merger Change in
Operations impact on incremental Cash Flows.
o  Use Old Present Value Equation:
PV = CF1 / (1+r) + CF2 / (1+r)  2 + CF3 / (1+r) 3 +...
o  Discount Rate (r) or Cost of Capital for Prospective Investors (i.e. Shareholders of the
Acquiring Firm i.e. rEL) so focus on Equity Value of Target Firm (not Total Value)
177
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Financial Management ­ MGT201
VU
Use CAPM Theory / SML to estimate rE (Required Return on Equity for
Shareholders) from Beta (or Relative Market Risk) of Target Firm. Then rE,L =
rRF + (rM - rRF) x BetaL .
Note that BetaL = BetaU [1 + (1-Tc) (D/E)]
Tc = corporate tax rate
D = Debt
E = Equity
Numerical Valuation of Target Firm Market Multiple Analysis (MMA):
·  Market Multiple Analysis (MMA) Approach to Merger Valuation is the most commonly used
because it is quick & easy. Approximate Formulas and Ad-hoc Rules of Thumb that change
with different Industries and change with Time depending on Macroeconomic Conditions in
country
·  Example of Market Multiples used in Pakistan:
­  Established Brand and Financially Healthy Textile Spinning Mill:
Firm Value = 10 x Annual Net Income (or Earnings)
The figure 10 comes from stock market reports analysis.
Based on Current Average P/E Multiple for Textile Spinning Sector = Average Market Price of
Share / Average EPS = 10.0
­  Financially Strong Operational Software House:
Firm Value = 7 x Annual Sales
­  Operational Mobile Phone Company:
Firm Value = Rs.100000 x Number of Connections
­  Value of Property in Pakistan = 10 x Annual Rental Income
Impact of Merger Price on Value of the Firm:
·  Impact of Merger Price on Value of Acquiring Firm:
­  If Negotiated Price for Target Firm > Fair Price (or DCF Value Estimate) for Target
Firm then Acquiring Firm's Shareholders will Lose Value.
It is so as shareholders are paying more than the fair worth of the target company.
·  Impact of Merger Price on Value of Target Firm:
­  If Negotiated Price per share of target firm > Market Price of Target Firm's share in
Stock Exchange then Target Firm's Shareholders will Gain Value
Shareholders are being paid price much higher than firm worth.
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios