Mil De Silva

University Name – Winter 2018 [Student Initials] Page 1 of 18 Course Code – Section # | Course Name – [Today’s Date] Chapter #: Chapter Title [Week #] Instructor: Instructor Name Office hours: Days of the week & hours available Phone number 416-XXX-XXXX, ext. XXXX Office: Office lcation Email: [instructor’s email] INTRO  For the last 2 weeks, we were using derivatives to manage risk  Today, we’re going back to value maximization by buying up other companies Agenda 1. Types of mergers 2. How to value a merger  Value of synergy 3. Cash vs. stock mergers 4. Evidence of M&A’s 5. Defensive tactics to an unfriendly acquisition [Lecture Title] How does M&A create value for shareholders? 2 companies involved  1 company buys the other company (the acquirer firm)  1 company is selling itself to the other company (the target firm) o Both companies’ managers are trying to make the best decisions for their shareholders (Target side- seller)  Management of a target has to decide how to pay back its shareholders. One way is to simply sell the firm at a good price and distribute the proceeds (Acquirer side- buyer)  Its not a payout decision, but an investment decision University Name – Winter 2018 [Student Initials]  Page 2 of 18 NPV rules- investment decision- a company should only purchase if it’s a +NPV investment. Should the firm buy a widget machine or a widget machine company? o Should the company create things from scratch or just buy a company that already has everything? Which alternative gives the company a higher NPV? M&A Terms Merger: 2 firms agree to combine their operations Acquisition: the acquiring firm purchases the voting shares of the target firm  Acquirer (or bidder): a firm that is the buyer in a M&A deal  Target: a firm that is acquired by another in a M&A deal Agenda 1. Types of mergers 2. How to value a merger  Value of Synergy 3. Cash vs. stock mergers 4. Evidence of M&A’s 5. Defensive tactics to an unfriendly acquisition Types of M&A Horizontal merger  When 2 competitors in the same line of business, targeting the same customers merge into one  E.g. Best Buy and Future Shop Vertical integration  Producer-supplier  E.g. Time Warner (movie company) and Turner (TV supplier company) Conglomerate  2 firms are operating in unrelated businesses o E.g. Kraft (food company) merged with Philip-Morris (financial firm) o Legal implications- e.g. AT&T (Telecom company) and Time-Warner (movie production firm) talking about a merger. The US justice is trying to block it because they have some horizontal relationships (they together will control too University Name – Winter 2018 [Student Initials] Page 3 of 18 much of the market, which gives them more pricing power, thus harming customers)  If they combine, that leaves little room for consumers to shop around and get a good price o E.g. Rogers, Shaw, Bell- they control telecom in Canada and that creates high cost for customers o When 2 firms combine, managers and CEOs in different businesses have to convert/expand their skills e.g. food business and insurance business combining is questionable. In the past businesses that hasn’t worked out well.  E.g. General Electric (GE)- In the 80s and 90s they expanded into many industries including financial services. However the last 20 years, the company is retracting and going back to its core business. Problem [Fill in the Blank] Kojack Film needs silver to make photographic film. To ensure that the company will have an ample supply of silver at a reasonable price, the company purchases a silver mine. This is an example of a vertical integration (C). Agenda 1. Types of mergers 2. How to value a merger  Value of Synergy 3. Cash vs. stock mergers 4. Evidence of M&A’s 5. Defensive tactics to an unfriendly acquisition Accounting for Acquisitions Purchasing Method  The fair market value of the target firm’s assets is reported on the books of the acquirer o Instead of using historical value, we benchmark the value at every year end University Name – Winter 2018 [Student Initials]    Page 4 of 18 o In case of acquisition, we look at how much firm is worth to general equity market (the transaction should be based on market value) Goodwill is created for accounting purposes (intangible asset) o Goodwill is an intangible asset that arises when the acquirer purchases the target firm at a premium (purchasing price is higher than market value) Goodwill is depreciated going forward Equity of the acquired firm is bought out (all the financial statements are now migrated into assets and liabilities of acquiring firm) Example #1: Value of Goodwill Company XYZ pays 9k to acquire ABC. Suppose the Net Fixed Assets of ABC have a fair market value (FMV) of 7k.  The acquiring firm is offering 9k to purchase equity of target firm  We can’t use book value, which reflects historical value (that may no longer reflect the current market price, so you use the fixed asset value of 7k) What will be the value of goodwill generated from this acquisition for XYZ? Even though market value is only $7300, the target company might be valuable to the acquirer because of synergy. This means that when the 2 firms combine into 1, extra value can be created. University Name – Winter 2018 [Student Initials] Page 5 of 18 Agenda 1. Types of mergers 2. How to value a merger  Value of Synergy 3. Cash vs. stock mergers 4. Evidence of M&A’s 5. Defensive tactics to an unfriendly acquisition Reasons to Acquirer: SYNERGIES NOTE: A= acquirer B= target Synergies are the value created from a merger.  The whole is worth more than the sum of the parts. VA+B= VA + VB Sources of Synergy  Economics of scale and scope o E.g. Future Shop + Best Buy  They share the same operating costs and now have 1 accounting department  E.g. Future Shop & Best Buy become 1 large seller of electronics and they have better bargaining power with suppliers  Integrated supply chain o Price of selling the product and price of buying the product- there is no risk o Horizontal- now the supplier will be a department within a firm- so no longer price volatility  Acquiring expertise o E.g. tech companies buying each other- software companies- most of the companies assets are (human resources) skilled workers, innovation- you can buy up a whole company that owns a patent to expand into a new area  E.g. Google buying YouTube lets them enter into the video market University Name – Winter 2018 [Student Initials] Page 6 of 18  Increasing market power o 2 firms combine into one and have more market share (not necessarily beneficial to consumers)  Replacing inefficient management o Target company has good business plan, good product or service, but only issue is that the managers are very inefficient. Lots of private inequity funds come in, fire old managers, bring in new managers and then sell the firm later NOTE: Are managers doing this for their own benefit or to benefit the shareholders for both firms?  Saving taxes from operating losses o E.g. start-up firm- a profit-making firm who buys them can take advantage of the tax savings Example #2: Tax Saving in M&As This can be the case for supplier and consumer; an oil company and an airline. The airline company would profit from the low oil price, and the oil producer would have a loss.  Assuming corporate tax of 40% and that no tax loss can be carried forward (it can’t be carried forward as a tax deduction)  The 2 firms can avoid risk and price volatility and get a fixed profit if they merge (a synergy benefit) NOTE: Change tax rate to 40% How can A&B both save tax if they merge? Both are using the – tax is non-deductible when 2 companies are operating independently. But when they are together, the tax is deductible (40% tax deduction), which results in increased profit. This is the tax advantage. NOTE: However, the tax rules are not always the same. P.T.O. University Name – Winter 2018 [Student Initials] Page 7 of 18 Estimating the Value of Synergies For the earlier example, the market value of the target firm is $7300, but the acquirer firm offers $9000 because there could be potential synergies. A financial expert would come up with numerical values for those synergies.    Suppose Firm A is planning to acquire Firm B The value of Firm B to Firm A: VB*= VB + S When the 2 firms combine, extra value is created by tax savings, combined operations, etc. (every year we can make these calculations and then combine them to put a numerical value on the synergies) University Name – Winter 2018 [Student Initials] Page 8 of 18 Example #3: Value of Synergies Does a merger generate synergies?  Every year there’s a $5000 savings  Both firms have Cost of Capital (CoC) of 12%. So that applies to the $5000 savings every year. P.T.O. University Name – Winter 2018 [Student Initials] Page 9 of 18 SUMMARY  There are 3 different kinds of mergers where the acquirer was willing to pay a premium because of the existence of synergy where the 2 firms combined to generate more profit.  Many investors in the stock market are thinking about these M&As. Financial side effect of M&A- EPS Increase  EPS is a measure of the profitability for shareholders  If the acquirer’s EPS goes up, that might only be the side effect of the M&A and it might not necessarily be value creating. Thus, you should also look at the price/ earnings ratio. Example #4: EPS Magic   The merger creates no synergies. So shareholders of neither firm will be better off. This matters because in the M&A context, EPS is not a good measure. With no synergies, the share price will stay the same. o Acquirer and target are both making $1 per share o Price/ earnings ratio- tells us how much growth the investors can expect from the firm. Measures the growth potential. EPS tells us how much profit the company made in the past year. Stock price- tells us how much profit the firm will make in the future. P/E = Price/ EPS    Price= PV (future earning) EPS= past earnings If this ratio is high, investors expect more from the firm A= global resources B= global prices  Before merger, share price= $25 & After merger, share price= $25 o So the merger didn’t have a benefit or harm to the shareholders.  So Earnings Per Share (EPS) seems high with $1.43 (boosted because share exchange rate is 1: 2.5), but there’s actually no synergy. P/E- The acquirer is making a higher EPS, but the growth potential has gone down. So the high growth acquirer is taking on a low-growth target (this is the cost they pay for a temporary boost from EPS).  University Name – Winter 2018 [Student Initials]  Page 10 of 18 Smart investors would see through this. You are sacrificing future potential growth rate (P/E), for current higher profit (EPS).  P.T.O. for [Part 2] University Name – Winter 2018 [Student Initials] Page 11 of 18 Agenda 1. Types of mergers 2. How to value a merger  Value of Synergy 3. Cash vs. stock mergers 4. Evidence of M&A’s 5. Defensive tactics to an unfriendly acquisition Cash & Stock Mergers Cash Acquisition (1st kind)  Acquiring firm pays target firm’s shareholders  The acquiring firm pays the target firm in cash for the target firm’s shares. The target firm’s shareholders now have nothing to do with the combined firm. Only the acquiring firm are now owners of all the shares. University Name – Winter 2018 [Student Initials] Page 12 of 18 (2ND Kind) Stock Offer/ Stock Acquisition  Both groups of shareholders have shares of the new firm  The acquiring firm pays with its own shares to target the firm’s shareholders in exchange for some control in the combined firm (post-merger firm)  There is no cash changing hands between the firms. Example #5: Cash Offer University Name – Winter 2018 [Student Initials] Page 13 of 18 Stock Acquisition For the acquiring firm, they are paying in their own shares. So we calculate the share cost. Example #6: Stock Offer Firm X plans to acquire Firm Y through a stock exchange. The exchange ratio is 0.5, which means for every 2 [Firm Y] shares, they will convert to 1 share of the combined firm. The synergy value of the deal is $4m. University Name – Winter 2018 [Student Initials] Page 14 of 18 a) What will be the share price of Firm X after the merger (or after the announcement of the merger)? b) What will be the share price of Firm Y after the announcement of the merger? c) What’s the takeover premium received by the shareholders? University Name – Winter 2018 [Student Initials] Example #5: Cont’d Stock Offer Page 15 of 18 University Name – Winter 2018 [Student Initials]   Page 16 of 18 Now suppose instead of making a cash offer, Firm A would like to offer Firm B a stock exchange What is the maximum exchange ratio that firm A could offer to Firm B so that the NPV of the acquisition is zero? Choosing between Cash vs. Stock Merger Sharing Gains  Target stockholders don’t participate in stock price appreciation in a cash acquisition o Cash merger: target is given cash o Stock merger: We know how many shares are being offered, but we don’t know the share value. Taxes  Stock acquisition: No cash changes hands for stock offer, thus no tax paid from target firm (tax exempted)  Cash offer: the target has to pay tax right away for capital gains tax (taxable) Control  Cash acquisitions do not dilute control Agenda 1. Types of mergers 2. How to value a merger  Value of Synergy 3. Cash vs. stock mergers 4. Evidence of M&A’s 5. Defensive tactics to an unfriendly acquisition Evidence on M&As [Market response to M&As] How is the value of synergy being shared between target firm and acquirer firm?  Target shareholders usually see their share value go up 10-30% as a result of the deal  Acquiring shareholders on average only make mild Why is that the case? Shouldn’t they split the benefit of the merger? University Name – Winter 2018 [Student Initials] Page 17 of 18 Hostile takeover bid  Canadian oil sands price went up straight away (over 40% increase in single trading day)  Acquiring firm: Suncor’s price didn’t move much and went down slightly (not good news for the market) Friendly merger side  Tim Horton’s price went up from $74 to $80 (10% increase)  Burger King (price went up): Burger King is an American-based company, and Tim Horton’s is a Canadian-based company, and Burger King (the acquirer firm) were moving their HQs to Canada because it had a good tax-base. Acquirer’s stock price reaction to takeover announcement Both target firms prices have gone up, why do the target firms have such favourable price reactions?  For the acquiring firm, its complicated to integrate the target’s firm into their own firm’s business plans  For target shareholders, they get a cash offer upfront. For a stock offer, the target shareholders can sell their shares and realize profit too. So there’s much less risk for target shareholders, and much more risk for acquirer shareholders  For the acquirer firm its an investment decision (the decision is to benefit managers, not shareholders) However, sometimes management may not be acting in the acquirer shareholders’ best interests.  Also, the takeover market may be competitive Hostile takeovers and takeover defense Hostile takeover: executive managers decide they don’t want their firm to be taken over (so if the target resists, its called a hostile takeover)  Tender offer: the acquiring firm directly buy shares from the shareholders of the target firm (without coming to an agreement with the target firm’s management) Agenda 1. Types of mergers 6. How to value a merger  Value of Synergy 7. Cash vs. stock mergers 8. Evidence of M&A’s 9. Defensive tactics to an unfriendly acquisition University Name – Winter 2018 [Student Initials] Page 18 of 18 Defensive Tactics Share rights plan (poison pill)  Building a clause into the shareholders’ contracts, where rights are attached to the firm’s shares that allow existing shareholders, except the acquirer, to buy new shares from the firm at a very low price when a hostile takeover occurs o E.g. Netflix’s plan in November 2012. It stopped a potential acquirer and diluted the stock because everyone else except that acquirer started running to buy the stock. Staggered/ classified boards  Only a fraction (typically 1/3) of the board of directors is elected each year o E.g. McDonald’s strategy [Other tactics]  Golden parachutes  Crown jewels  White knight  Greenmail *Example #7 (combination of cash and stock merger) do this for homework 