Transcript Oil and Gas Business

Chapter 21
Mergers, LBOs, Divestitures,
and Holding Companies
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Types of mergers
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Merger analysis
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Role of investment bankers
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LBOs, divestitures, and
holding companies
Merger & Acquisition (M&A)
Acquisition & Divestment (A&D)
Investment & Divestment (I&D)
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Reasons for Mergers
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Synergy: Value of the whole exceeds sum of the parts. Could
arise from:
 Operating economies
 Financial economies
 Differential management efficiency
 Taxes (use accumulated losses)
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Break-up value: Value of the individual parts of the firm if they
are sold off separately. If it’s higher than current market value,
the firm could be acquired then sold off in pieces to earn a profit.
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Diversification.
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Acquire other firms to increase size, thus making it more difficult
to be acquired.
Why Buying an Asset or Business?
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Access to resources
Proximity to market and infrastructure
Buy or build growth strategies
Achieve critical mass
Enter new markets / increase market share
Acquire technological know-how / intellectual property
Complement existing business
Diversify product or business portfolio
Defence tactics/ elimination of competitors
Benefit from synergies
Long term investment
Securing supply chain
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Types of Mergers
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Horizontal Merger
Vertical Merger
Conglomerate Merger
Friendly vs Hostile Mergers
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Friendly merger:
 The merger is supported by the managements of
both firms.
Hostile merger:
 Target firm’s management resists the merger.
 Acquirer must go directly to the target firm’s
stockholders to tender offer their shares.
 Often, mergers that start out hostile end up as
friendly, when offer price is raised.
Parties Involved
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Acquisition Process
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Target Valuation Approaches
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Market Multiple Analysis
Corporate Valuation Model
Equity Residual Model
Adjusted Present Value (APV)
Market Multiple Model
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Using multiple ratio (P/E, P/CF, P/S, P/BV, etc) of
industry average or comparable peer.
Multiplying that ratio to estimated figures of
target’s earnings/cash flow/sales/book value, etc.
Easy to estimate but least accurate
Provide a ballpark estimate
Corporate Valuation Model
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Forecasting Pro Forma Financial Statements,
determining Free Cash Flow
Determine Value of operations added with Value
of nonoperating assets: Total Corporate Value
Less value of debt & preferred stocks: value of
common equity
More suitable if WACC & capital structure is
relatively stable
Equity Residual Model
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Also called Free Cash Flow to Equity (FCFE)
model
Estimate the value of equity as PV of projected
FCF to equity, discounted at required return on
equity.
FCFE = cash flow available for shareholders after
making debt related payment (interest &
principal), adding debt in operating capital.
More suitable if capital structure is relatively
stable as change in capital structure may cause
cost of equity to change.
Adjusted Present Value (APV)
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Often in a merger the capital structure
changes rapidly over the first several years.
This causes the WACC to change from year
to year.
The APV Model
Value of firm if it had no debt
+ Value of tax savings due to debt
= Value of operations
First term is called the unlevered value of the
firm. The second term is called the value of
the interest tax shield.
The APV Model
Unlevered value of firm = PV of FCFs
discounted at unlevered cost of equity, rsU.
Value of interest tax shield = PV of interest tax
savings at unlevered cost of equity. Interest
tax savings = (Interest) x (tax rate) = TSt =
Tax Shield.
Note to APV
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APV is the best model to use when the
capital structure is changing.
The Corporate Valuation model is easier than
APV to use when the capital structure is
constant—such as at the horizon.
Steps in APV Valuation
1.
2.
3.
4.
5.
Project FCFt ,TSt , horizon growth rate, and
horizon capital structure.
Calculate the unlevered cost of equity, rsU.
Calculate WACC at horizon.
Calculate horizon value using constant growth
corporate valuation model.
Calculate Vops as PV of FCFt, TSt and horizon
value, all discounted at rsU.
APV Valuation Analysis (In Millions)
Projection of Free Cash Flows
2004 2005 2006 2007
Net sales
$60.0 $90.0 $112.5 $127.5
Cost of goods sold (60%)
36.0 54.0
67.5 76.5
Selling/admin. expenses
4.5
6.0
7.5
9.0
EBIT
19.5 30.0
37.5 42.0
Taxes on EBIT (40%)
7.8 12.0
15.0 16.8
NOPAT
11.7 18.0
22.5 25.2
Plus Depreciation
0.0
3.0
4.0
5.0
Operating Cash Flow
11.7 21.0
26.5 30.2
Less Gross Inv. In Opr Capital 0.0 10.5
10.0
9.5
Free Cash Flow
11.7 10.5
16.5 20.7
Projection of Interest Tax
Savings after Merger
2004
Interest expense
Interest tax savings
5.0
2.0
2005
6.5
2.6
Interest tax savings are calculated as
Interest x Tax Rate. T = 40%
2006
6.5
2.6
2007
7.0
2.8
Discount Rate: Comparison of APV
with Corporate Valuation Model
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APV discounts FCF at rsU and adds in present
value of the tax shields—the value of the tax
savings are incorporated explicitly.
Corp. Val. Model discounts FCF at WACC,
which has a (1-T) factor to account for the value
of the tax shield.
Discount rate for Horizon
Value
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At the horizon the capital structure is
constant, so the corporate valuation model
can be used, so discount FCFs at WACC.
Calculation of Discount Rates
Assumptions:
rRF = 7%; (rM - rRF) = 4%; bTarget = 1.3; rD = 9%
Growth at Horizon, g = 6%
Current Capital Structure (assumed to be returned at horizon):
wd = 20%; ws = 80%
rsL
= rRF + (rM - rRF)bTarget
= 7% + (4%)1.3 = 12.2%
Equation 17-15
rsU
= wdrd + wsrsL
= 0.20(9%) + 0.80(12.2%) = 11.56%
WACC
= wd(1-T)rd + wsrsL
=0.20(0.60)9% + 0.80(12.2%)
= 10.84%
Calculation of Horizon Value
Horizon value
(FCF2007 )(1 g)
=
WACC  g
= $20.7(1.06)
0.1084  0.06
= $453.3 million.
Value of the Target Firm’s Operation
2004
Free Cash Flow
Horizon value
Interest tax shield
Total
VOps
=
$13.7
(1.1156)1
= $344.4
2005
2006
2007
$11.7 $10.5 $16.5 $ 20.7
453.3
2.0
2.6 2.6
2.8
$13.7 $13.1 $19.1 $476.8
+
$13.1
(1.1156)2
+
$19.1
(1.1156)3
+
$476.8
(1.1156)4
What is the value of the
Target’s equity?
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The Target has $55 million in debt.
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Vops – debt = equity
344.4 million – 55 million = $289.4 million =
equity value of target to the acquirer.
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Would Another Potential Acquirer
Obtain the Same Value?
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No. The cash flow estimates would be
different, both due to forecasting
inaccuracies and to differential
synergies.
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Further, a different beta estimate,
financing mix, or other assumptions
would change the discount rate.
Offer Price: Assumptions
Assume the target company has
20 million shares outstanding. The stock
last traded at $11 per share, which reflects
the target’s value on a stand-alone basis.
How much should the acquiring firm offer?
Offer Price: Calculation
Estimate of target’s value = $289.4 million
Target’s current value
= $220.0million
Merger premium
= $ 69.4 million
Presumably, the target’s value is increased by $69.4 million due to
merger synergies
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The offer could range from $11 to $289.4/20 = $14.47 per share.
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At $11, all merger benefits would go to the acquiring firm’s
shareholders.
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At $14.47, all value added would go to the target firm’s
shareholders.
Change in
Shareholders’
Wealth
Acquirer
Target
$11.00
0
5
$14.47
10
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Bargaining Range =
Synergy
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Price
Paid for
Target
Offer Price: Bargaining
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Actual price would be determined by bargaining. Higher
if target is in better bargaining position, lower if acquirer
is.
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If target is good fit for many acquirers, other firms will
come in, price will be bid up. If not, could be close to
$11.
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Acquirer might want to make high “preemptive” bid to
ward off other bidders, or low bid and then plan to go
up. Strategy is important.
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What kind of personal deal will target’s managers get?
Due Diligence
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Due Diligence: Financial
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Review of past historical performance (generally the last
3 years)
Review of key assets and liabilities
Review of profitability
Identification of hidden exposure (incl. tax exposure),
commitments, contingencies and other unrecorded
liabilities
Review of transactions with related parties
Identification of key Generally Accepted Accounting
Principle differences (if required)
Review of compliance matters and other relevant
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regulations
Due Diligence: Tax
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Review of status tax filing and payment and other tax
compliance practices
Identify potential tax exposure on major commercial
arrangements
Analysis of any outstanding dispute with the Tax Office
Review of tax facilities, if any
Review of material related party transactions and
highlight potential transfer pricing issue
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Sales & Purchase Agreement:
Key Areas
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Timeline
Consideration
Condition Precedent
Representation & Warranties
Tax Matters
Indemnification
Book & Records
Due Diligence
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Why alliances can make more
sense than acquisitions
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Multiple parties share risks and expenses
Rivals can often work together harmoniously
Avoiding antitrust laws
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Alliance, JV & Merger
Example: Royal Dutch Shell
Shell
Royal Dutch
Royal Dutch Shell
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The Role of Investment Bankers
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Identifying targets
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Arranging mergers
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Developing defensive tactics
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Establishing a fair value
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Financing mergers
Reasons for Divestiture
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Subsidiary worth more to buyer than when
operated by current owner.
To settle antitrust issues.
Subsidiary’s value increased if it operates
independently.
To change strategic direction.
To shed money losers.
To get needed cash when distressed.
Leveraged Buy Outs (LBOs)
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In an LBO, a small group of investors,
normally including management, buys
all of the publicly held stock, and hence
takes the firm private.
Purchase often financed with debt.
After operating privately for a number of
years, investors take the firm public to
“cash out.”
Why Sell a Business or an Asset?
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A change in strategic focus
An underperforming division
A mature division with limited growth prospects
Maximizing shareholder value
A need for cash to finance other expansion opportunities
The retirement of the owners
Industry consolidation
Liquidity issues
Unable to expand without additional financial assistance
Changing Technology
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Potential Deal Issues
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Seller/Buyer’s Expectations
Potential Tax Exposure
Availability of Information & Time for Due
Diligence
Legal & Regulation Issues
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Holding Companies
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A holding company is a corporation formed
for the sole purpose of owning the stocks of
other companies.
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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.
Holding Companies:
Advantages & Disadvantages
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Advantages:
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Control with fractional ownership.
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Isolation of risks.
Disadvantages:
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Partial multiple taxation.
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Ease of enforced dissolution.