Mergers and Acquisitions notes PDF

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Mergers and AcquisitionsLecture 1LM&A Terminology – GeneralTakeover – any acquisition of corporate control through the purchase of the voting stock of the target firmMerger – a combination of two (or more) firms, often comparable in size; negotiated transaction between the two firms; often f...

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Mergers and Acquisitions Lecture 1L M&A Terminology – General Takeover – any acquisition of corporate control through the purchase of the voting stock of the target firm Merger – a combination of two (or more) firms, often comparable in size; negotiated transaction between the two firms; often friendly (firms are same size) Acquisition – a company takes a controlling interest in another firm, a legal subsidiary or selected assets of another firm; sometimes hostile (firms are not the same size)

M&A Terminology – Economic Perspective • Horizontal – acquisition of a firm in the same industry, “buying the competition” • Vertical – acquisition of a firm up or down the supply chain, “supply chain integration” Inbound logistics => Operations/production => Marketing => Distribution/sales => Customer support =>=>=>=>=>=> Forward integration =>=>=>=>=> 73.5% set discount rate using CAPM (Source: Graham and Harvey, Journal of Financial Economics, 2001.)

Capital Asset Pricing Model • CAPM

• An asset’s risk premium is the product of its beta and the market risk premium. Some general implications of the CAPM: • Only market risk is “priced”: (Expected) returns are only earned as compensation for bearing market risk. All other (idiosyncratic) risk can be diversified away. If we don’t have diversified portfolio, we cannot ignore the asset’s idiosyncratic risk. • Covariance (with the market) is everything: β = cov(ri , rm)/var(rm), so higher covariance with the market return => higher beta = higher risk => higher return!

Implementing the CAPM in practice We need three inputs:

• Beta: Estimate the stock’s beta, or sensitivity to the market portfolio • Risk-free rate • Market risk premium: Construct the market portfolio and determine its expected return over the risk-free interest rate Note that only beta is security specific; the other two inputs are marketwide and should be the same for all securities/projects in the economy.

Beta Estimation • Historical Returns • •

We would like to know a stock’s beta in the future: how sensitive will its future returns be to market risk? In practice, we estimate beta based on the stock’s historical sensitivity. This makes sense if a stock’s beta remains stable over time, which turns out to be the case for most firms.

• Amount of data • • •

If we use too short a time horizon, our estimate of beta will be unreliable. If we use a very long horizon, then information might be stale and not a good representation of the future. If we use very old data, they may not be representative of the current market risk of the security. For stocks, common practice is at least five years of monthly data.

Monthly returns for Cisco and S&P 500

This means Beta of Cisco is higher than 1

Cisco’s Excess Returns vs. the S&P 500’s excess returns

R^2 is less than 50%, this means that less than 50% of the variation in Cisco’s stock returns is explained by the CAPM.

Beta Estimation for Ido • Comparable publicly traded firms: • Oakley (βE=1.50) • Luxottica (βE=0.75) • Nike (βE=0.60)

Risk-Free Rate

• For example, the yield on U.S. Treasury securities • Short term T-Bills • • •

Lower interest rate risk (+) Firms have longer horizons in raising capital for their projects (-) Investors might have longer horizons when committing funds to firms (-)

• Long term T-Bonds • •

Greater interest rate risk (-) Likely to be a better match for firms’/investors’ investment horizon (+)

• Most practitioners use 10-year treasuries

Market Risk Premium • Expected excess return of the market portfolio = E(rM )– rF • It gives us the benchmark by which we assess an investor’s willingness to hold market risk. • What is the market portfolio? • •

Most practitioners use the S&P 500 as the market proxy. Although S&P 500 includes only 500 of the more than several thousand individual stocks existing, it represents more than 70% of the US stock market in terms of market cap.

Estimating the market risk premium… • Historical risk premium • Estimate the risk premium (rM-rF) using the historical average excess return of the market over the risk-free interest rate Historical Excess Returns of the S&P 500 Compared to One-Year and Ten-Year U.S. Treasury Securities

Most researchers and analysts believe that future expected returns for the market are likely to be more similar to the more recent historical numbers, in a range of about 3-5% over longer-term Treasury bonds.

Valuing Ido • PV of FCFs from 20X1 to 20X5

• Continuing Value, 20X6 onwards…. • Constant debt-equity (D/E) ratio = 2/3 Debt-to-value ratio (D/D+E) = 40% rD = 6.8% • Constant expected growth rate, g = 5%

Multi-Period Projects • Consider a project that is expected to produce a cash flow of $100 in each of the next two years. • The risk-free interest rate is 6%, the market risk premium is 8%, and the project’s beta is 0.75, so that the project’s expected return is r = 0.06 + 0.08(0.75) = 0.12. • The present value of the first cash flow is 100/1.12=89.29. • If that cash flow had been riskless, it would have been discounted at 6%, i.e., its present value would be 100/1.06 = 94.34. • So, to get PV1, we effectively discounted the cash flow at 6% to account for the time value of money, and by (94.34/89.29) – 1 = 5.66% to account for risk.

Multi-Period Projects (cont’d) • Now, if we were to discount the second cash flow at 12% for two years, we would obtain

• We have discounted for 2 years for both the time value of money and risk. Why?

• If both cash flows had the same risk, then it would perhaps be more appropriate to calculate the present value as follows:

• Therefore, by using a constant discount rate, we are effectively making a larger deduction for risk for the later cash flows By using constant discount rate we account for riskiness of cash flows as well as time value of money

Dangers of Using Company-Wide Rates

Lecture 6L – Leveraged Buyouts (LBOs) Review: CAPM

• CAPM • An asset’s risk premium is the product of its beta and the market risk premium. • Some general implications of the CAPM: • •

Only market risk is “priced”: (Expected) returns are only earned as compensation for bearing market risk. All other (idiosyncratic) risk can be diversified away. Covariance (with the market) is everything: β = cov(ri , rm)/var(rm), so higher covariance with the market return => higher beta = higher risk => higher return! € ri = rf + βi rM − r ( f) rf = Riskfree rate; rM = Marketreturn

Which Statements are True According to the CAPM? a. The CAPM can be used to price both debt and equity claims. b. The beta of a levered firm is always lower than its equity beta. T c. Investors may have different estimates about the volatilities and expected returns of securities. F d. The fact that stocks of small firms earn higher returns than stocks of large firms is inconsistent with the CAPM. F

Which Statements are False? a. The company’s cost of capital is the correct discount rate for projects undertaken by the firm. F b. Cost of assets is the same as cost of equity for firms financed entirely by equity. T c. Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that more distant cash flows are riskier. F d. Calculating a firm’s debt-to-equity ratio requires the use of the book values of debt and equity. F

Entergy & Superior Oil Entergy, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing separately in different natural gas wells near Pittsburgh. The well that Entergy is thinking of investing in is located north of Dallas while Superior Oil’s would be south of Dallas. But otherwise, the projects are identical. Both companies estimate that their project would have an NPV of $1M at a 12% discount rate and a $1.1M at a 16% discount rate. Entergy has a company beta of 1.25 and Superior Oil has a company beta of 0.75, which is equal to the beta of natural gas production. The expected risk premium on the market is 8% and risk-free bonds are yielding 6%. Who should invest? a. Entergy

b. Superior Oil c. Both firms d. Neither firm.

Conglomerate Discount Rate Mix Inc. is a large conglomerate that manufactures computer chips, lawn sprinklers, and luggage, among other items. ComCorp is a computer chip manufacturing company whose size is similar to that of Mix Inc. Mix Inc. and ComCorp both have company betas of approximately 1 (according to the CAPM). One would expect that the fraction of the total variability of each company’s stock returns that is due to unique risk is: a. Higher for ComCorp than for Mix Inc. b. Lower for ComCorp than for Mix Inc. c. Probably similar because size and betas are similar. d. Cannot be determined from the information given.

Today’s Learning Objectives • Leveraged buyouts • • • •

Motives Consequences Exits Institutional details of LBO market

• The LBO “valuation” model

LBOs and MBOs • Leveraged buyout (LBO) • •

Acquisition of the stock of a company using a small amount of equity relative to the overall purchase price Going-private deal – a public company is taken private; when the deal is financed mostly with debt, also referred to as an LBO

• Management buyout (MBO) – transactions where the buyers are managers • •

Example: Public company divesting a division When managers use mostly debt, also referred to as an LBO

Financing of LBOs

• Most financing comes from debt: • •

New D/V ratio typically between 60-80% Debt paid down over 3-5 years using the FCF of the firm

• New equity (cash) provided by the PE sponsor and/or management • •

Preferred stock for PE – results in accrued dividends; PE sponsors tend to specialize by industry or firm size Management rolls over shares – results in less equity to purchase and often higher ownership for management

PE Firms in the M&A Market

Top PE Firms

PE Investment Horizon

LBO Capital Structure

Senior Debt • Senior debt – 30-50% of total debt financing • •

Secured by company assets Maturity – 5 years or more; Interest – Prime plus 2-3%

• Revolving credit • •

Secured by short-term assets (inventory, accounts receivable) Maturity – 5 years; Interest – Prime plus X%; Commitment fee

• Term Loans – investment grade or non-investment grade • •

Fixed amortization schedule, set loan period Term A vs. Term B loans – depending on how fast we pay it

Subordinated Debt • Intermediate-term debt – 20-30% of total debt financing • •

Maturity – 6-10 years; Interest – Prime plus 4-7% (higher risk) May include warrants

• High yield or junk bonds – rating of BB/Ba or worse • •

Maturity – 7-10 years; Interest – Gov. bond rate plus premium (credit worthiness) May include call protections (cannot prepay debt)

• Bridge loans – sometimes needed for closing

•

Provided by investment banks for a fee

Standard Debt Paydown Strategy

What Companies Make Good LBO Candidates? • Stable operating cash flows – lot of debt taken which needs to be repaid on time • High cash balances • Strong management – able to produce stable cash flows • Tangible (monetizable) assets – can be sold to repay debt • Low capital expenditures and R&D • Undervalued or underperforming (relative to peers) • Underleveraged (relative to cash flow)

How Do PE Firms Add Value? • Multiple expansion – raise the exit multiple • Margin expansion – EBITDA • • • •

Increasing top-line growth (revenues) Optimizing working capital management Decreasing costs (COGS or SG&A) Accelerating the cash conversion cycle

• Generate value via incentivizing management!

Exit Strategies

Exit investment in 3-7 years (typically modeled with a 5-year horizon) • Sale to a third-party – could be a strategic or another financial buyer • IPO – take the company public again •

Called a Reverse LBO

• Recapitalization – issue new debt to buy up some of the equity • •

Enables owners to cash out Can be used to pay dividends to owners

Which Statement Is True? a. When a public company is subject to a leveraged buyout, it is said to be “going private.” b. LBO firms rarely use the uncommitted assets and operating cash flow of the target firm to finance the transaction. c. High growth firms with high reinvestment requirements often make attractive LBO targets. d. LBO investors seldom sell assets to repay debt used to acquire the firm.

LBOs: US vs. Europe (1980-2016)

Top 10 US LBOs

Top 10 European LBOs

P/E Ratios Over Time

Advantages and Disadvantages of LBOs Advantages • Tax shields • Freedom from being public • Discipline of debt (next slide) • Increase of managerial ownership (last three points: Incentivize managers to work harder; reduce agency problems)

Disadvantages • Must generate high cash to service debt • Increased probability of distress and bankruptcy • High required return by investors

How Does Debt Affect Managerial Behavior? • Debt limits free cash flows •

Large debt obligations limit managerial ability to use corporate resources in ways that do not benefit investors

• Fear of bankruptcy can be a good motivator

• • •

Failure to repay debt triggers the transfer of control from managers to lenders 57% of CEOs lost jobs after bankruptcy Some large bankruptcies: TXU (2014), Harrah’s (2015), Clear Channel (2018), Tribune Company (2008)

Long-Term Effects of LBOs • Net reduction in employment of 1% • • •

Employment in existing operations declines by about 3% But employment at new ventures increases by about 2% Employment at private firms may increase

• LBOs often increase R&D and capital spending relative to peers • Improved operating performance (particularly for private LBO targets) due to increased access to capital and professional management

In Recent Years, LBO Premiums Tend to Be… a. 20% b. 70% c. 5% d. Less than typical mergers e. More than typical mergers

Valuing an LBO Construct standard standalone DCF model • Forecast CFs over horizon dictated by the sponsor’s exit strategy (e.g., 5 years) • Incorporate ways in which the sponsor adds value – improve sales/ reduce costs Sponsor evaluates post-financing CFs – equity residual CFs • Subtract out debt payments (levered free cash flow) • (EBIT – Net Interest Expense)*(1 – T) = Net Income – Principal Payments • Then, standard DCF • •

Add back depreciation & amortization Subtract Capex & increases in NWC

Valuing an LBO (2)

• Estimate terminal value • •

Typically based on EV/EBITDA multiple (often similar to entry multiple) Subtract net debt outstanding at exit

• Compute the equity investment that supports the required IRR of the PE sponsor •

Usually, 20% or higher!

Comparing WACC to RCF Approaches • Two important differences: 1. WACC approach uses prefinancing (unlevered) CFs; RCF approach uses post-financing CFs 2. WACC approach assumes a constant leverage ratio; RCF makes the same assumption but bypasses it by calculating an IRR APV approach -> uses unlevered cost of equity; adds tax benefits separately!

Which Tends to be True of LBOs? a. LBOs rely heavily on management incentives to improve operating performance b. Tax benefits are predictable and are built into the purchase price premium c. The cost of equity is likely to change as the LBO repays debt d. Investors typically require high returns in LBOs e. All of the above

Lecture 6P – Adjusted PV (APV) Analysis Learning Objectives • Illustrate the use of the APV model • Discuss advantages and disadvantages of the APV model compared to the WACC method • Consider scenarios in which the APV method is preferred

Valuing Ido…

Two Major Limitations of the WACC Method What does the WACC method assume about a firm’s debt level? • The WACC method assumes that the firm maintains constant debt ratio D/V. • •

This implies that any new project must be financed with debt and equity consistent with the firm’s fixed D/V. If a firm has a D/V = 50%, any new project must be financed with 50% debt.

What do we assume about managerial flexibility? • The WACC method implicitly assumes that future cash flows have to be passively “accepted” by the firm. •

In reality, managers have the flexibility to respond to changing circumstances – for example, to shut down a mine if gold prices plummet, abandon a drug if it is unlikely to get FDA approval, or expand a sports stadium if the team performs unexpectedly well.

WACC Method

APV Method

Incorporating the Financing Decision in Project Valuation • WACC method: Discount the project’s cash flows using an adjusted cost of capital that takes into account its financing as well as risk. • APV method: Calculate an adjusted NPV (APV): the sum of the NPV of the project (i.e., the NPV for an all-equity firm) and the NPV of the financing decisions. • The APV method incorporates the value of the interest tax shield directly rather than by adjusting the discount rate as in the WACC method.

Incorporating the Financing Decision in Project Valuation • The APV method separates the value of running the business (VU) from the value created by financing (PV(TS)). • Calculate each component of the APV separately: • Value of the project as if all-equity financed. Discount FCFs by rA. • Add the present value of the tax shield generated by the project

Advantages/ Disadvantages of APV • What are the advantages of APV? • • •

Less strict assumptions (no need to assume constant D/E) Clearer: Easier to track down where value comes from More flexible: Just add other effects as separate items

• What are the disadvantages of APV? •

More complicated: Used in specialized cases

• Conclusion: For complex, changing and highly leveraged capital structure (e.g., LBO), APV is much better.

APV Is Useful in Complex Scenarios… … where we need to track where value comes from: a. Evaluating large international projects. b. A state government imposes restrictions on project cash flows. c. There exists a tax subsidy of debt.

Lecture 7 – Abnormal Returns & Event Studies Review: The APV Method • The APV method separates the value of running the business (VU) from the value created by financing (PV(TS)).

Calculate each component of the APV separately: • Value of the project as if all-equity financed. Discount FCFs by rA.

• Add the present value of the tax shield generated by the project.

Financing Effects Included in APV Are… a. Tax subsidy of dividends, cost of issuing new securities, subsidy of financial distress and cost of debt financing b. Cost of issuing new securities, cost of financial distress, tax subsidy of debt and other subsidies c. Cost of issuing new securities, cost of financial distress, tax subsidy of dividends and cost of debt financing d. Subsidy of financial distress, tax subsidy of debt, cost of other debt financing and cost of issuing new securities

Which Statements are True? a. The APV is not suitable for international projects. F b. Government loan guarantees for firms may increase the APV by reducing bankruptcy risk. T c. The APV is preferred to the WACC method when we want to track down where value comes from. T d. The APV and the WACC methods bot...