Corporate Valuation and Financing

1. Corporate Valuation and Financing M&As H. Pirotte

2. Some history Great M&A wave in the 80�s 3�336 M&As (1986) in US Colder in the first mid 90�s Hot again in second mid 90�s to 2000 9�566 M&As (2000) in US with 1�097 valued at > $100 mns Typology Majority: negotiated acquisitions Minority: tender-offers Even less: hostile takeovers T. Boone Pickens, Ron Perelman, Jimmy Goldsmith, Carl Icahn,� H. Pirotte 2

3. Some numbers H. Pirotte 3

4. Alternative Ownership Strategies Growth strategies Mergers � one unit from two (or more) previous units Tender offers � method of making takeover via direct offer to target firm shareholders Pooling of interest � combination of fin�l statements of two (or more) firms Joint ventures � combination of subsets of assets for a specific purpose and duration Other forms Supplier networks Alliances Investments � stake, but not control in another organisation Franchising Shrinkage strategies Divestitures � sale of a segment to 3rd party for cash or securities Equity carveouts � parent firm offers some of a subsidiary�s common stock to the general public, to bring in a cash infusion without loss of control Spin-offs � creation of new public cy out of subsidiary with share distribution on pro-rata Splitoffs � some shareholders receive subs.�shares in exchange of the interest in parent firm Splitups � spinoff of all subsidiaries and no more parent firm Tracking stock � a separate class of common stock of a company that tracks the perf of a particular segment or division H. Pirotte 4

5. Changes in Ownership Structure Exchange offers Right or option to exchange one class of security for another Share repurchases A public corporation buys its own shares (a) by tender offer, (b) on the open market, or (c) in negotiated buybacks Leveraged buyouts (LBOs,MBOs) The purchase of the company by a small group of investors, financed largely by debt Leveraged recapitalizations A large increase in the leverage ratio to finance the return of cash to shareholders Employee stock ownership plans (ESOPs) A defined contribution pension plan designed to invest primarily in the stock of the employer firm Dual-class recapitalization Creation of two classes of common stock, with the superior-vote stock concentrated in the hands of management Reverse Takeovers (RTOs) H. Pirotte 5

6. Governance � Corporate control Compensation arrangements Payment forms to align interests of managers, owners and employees Proxy contest An attempt by a dissident group of shareholders to gain representation on a firm�s board of directors Premium buy-backs (greenmail) The repurchase of specified shares, usually from a party seeking to take over a firm Takeover defenses Methods employed by targets to prevent success of bidder�s efforts Stakeholder relationships Ethics and reputation H. Pirotte 6

7. Motivation H. Pirotte 7

8. Motivation H. Pirotte 8

9. M&As basic forms Mergers Absorption of a firm by another, combination of assets and liabilities Acquired firm cease to exist Specificity: consolidation (an entirely new firm is created) Acquisitions Of Stock Purchase of voting stock in exchange for cash, shares, or other securities May start as a private offer but then is offered to all selling shareholders (tender offer by public announcement) Differences with mergers? No shareholder�s meeting, nor vote is required Target�s firm management and board can be bypassed Often unfriendly A minority of shareholder may hold out and target cannot be completely absorbed Complete absorption required a merger. Many acquisitions end up with formal merger Of Assets Formal vote is necessary Avoid potential problem of having minority shareholders Legal process of transferring assets can be costly H. Pirotte 9

10. M&As basic forms (2) Classification Horizontal acquisition Vertical acquisition Conglomerate acquisition Note on takeovers general and imprecise term referring to the transfer of control of a firm from one group of shareholders to another. Bidder: firm that has decided to take over another firm Payment: cash or stock The right to control the operating activities of the target firm is transferred to a newly elected board of directors of the acquiring firm. This is a takeover by acquisition. Going private all the equity shares of a public firm are purchased by a small group of investors. The group usually includes members of incumbent management and some outside investors. The shares of the firm are delisted from stock exchanges and can no longer be purchased in the open market. H. Pirotte 10

11. Valuation As for any other investment project: DCF analysis But difficulties� Synergies, Legal effects, Tax impacts, Accounting impacts, Agency costs,� Problems Allocation of the NPV (?V=?D + ?E) Value impacts of using takeover defenses Advices Do not ignore market values Estimate only incremental cash flows Use the correct discount rate Do not ignore transaction costs H. Pirotte 11

12. Valuation H. Pirotte 12

13. Valuation H. Pirotte 13

14. Debate Big debate on costs and benefits of takeovers Pros Cons The classical explanation: synergies H. Pirotte 14

15. Example (case 1) A buys B and pays in cash VA = 1000, VB = 200 A has 20 shares, value of 50 B has 10 shares, value of 20 Synergy = 200 VAB = 1400 A pays 300 to buy back B Gain for A shareholders: = VA ap. fusion � VA av. fusion = 1100 � 1000 = 100 B shareholders receive 300 for their firm that has a value of 200 VAN = Synergy � Premium The merger�s synergy can be expressed through�: VAB � (VA + VB) Synergie = 1400 � 1200 = 200 Premium = 300 � 200 = 100 VAN = 200 � 100 = 100 H. Pirotte 15

16. Example (case 1) How are share values modified�? For A shareholders�: PA before the merger = 1000/20 = 50 PA after the merger = 1100/20 = 55 For B�shareholders : Before the merger�: 200/10 = 20 After the merger�: 300/10 = 30 H. Pirotte 16

17. Example (case 2) A pays B with shares : exchange ratio of 0.6 ? 6 A shares mean 6 ? 50 = 300 Value of AB share: PAB = 1400/ 26 = 53.85 B shareholders have: 1400 ? 6/26 = 323.08 The calculation is not correct because it is based on prices before the merger. B shareholders will own ? in AB ? must correspond to the proportion of new shares issued Shares to issue = 5.46 H. Pirotte 17

18. Example (case 2) Total number = 20 + 5.46 = 25.46 Exchange ratio = 0.546 PAB = 1400/25.46 = 55 Price paid by B shareholders�: 5.46 ? 55 = 300 H. Pirotte 18

19. Sources of Synergies Revenue enhancement Marketing gains Strategic benefits Market or Monopoly Power Cost reduction Economies of scale Economies of vertical integration Complementary resources Elimination of inefficient management Tax gains Net operating losses Unused debt capacity Surplus funds The Cost of Capital Why???? H. Pirotte 19

20. Tobin�s Q Tobin�s Q = Market value / Book value Indicator of under- or over-valuation A buys back B Tobin�s Q of B = 0.6 Premium of 50% B is under-valued Tobin�s Q ? main information engine H. Pirotte 20

21. Introduction - List Total value increased Efficiency increases Operating synergy Financial synergy Strategic realignements The q-ratio Information Signaling Hubris: acquirer overpays for target Agency: managers make value-decreasing mergers to increase size of firm Redistribution Taxes � redistribution from government Market power � redistribution from customers Redistribution from bondholders Labor � wage renegotiation Pension reversions Conglomerate mergers H. Pirotte 21

22. Information theories Upward revaluation of shares of target firm(Bradley [1980], Dodd & Ruback [1977]) Upon announcement? Yes, but also permanent ? new information has been gen! Even if offer turns out to be unsuccessful Two hypothesis �Sitting on a gold mine� (Bradley, Desai & Kim [1983]) Tender offer disseminates information that firm is undervalued only �Kick in the pants� Tender offer inspires target firm management to implement a more efficient business H. Pirotte 22

23. Hubris and winner�s curse Winner�s curse The successful bidder is the one paying too high a price Capen, Clapp & Campbell [1971] : analysis of sealed-bid competitive lease sales Ratio of high estimate to true value as a function of uncertainty and the number of bidders Hubris (Roll[1986]) If EMH verified, then target market price should reflect true value. Higher valuation of bidders results from hubris. Potential cause of winner�s curse: even if synergies, competition of other bidders could cause the winning one to pay too much. H. Pirotte 23

24. Agency problems Theories following the paper of Jensen & Meckling [1976] Partial ownership may cause managers to work less vigorously. In large corporations with dispersed shareholdings, not enough incentive to monitor managers. Agency problems arise because contracts between managers and owners cannot be enforced at no cost. Ideas Changes in ownership & control as a solution to agency problems Managerialism (e.g. for conglomerates (Mueller[1969])) The free cash flow hypothesis H. Pirotte 24

25. Gains to target firm�s shareholders H. Pirotte 25

26. Takeover defenses Types Poison pills (ex: in the incorporation status) Merger approval with 90% of votes Golden parachutes Voting rights and proxy fights Assets sale (ex: vente de la division recherch�e) ��burned land�� policy ... Is it good for the shareholder? Entrenchment versus firm protection H. Pirotte 26

27. H. Pirotte |27 References Copeland, Weston & Shastri (2003), Financial Theory and Corporate Policy, 4e, Addison Wesley. Ross, Westerfield and Jaffe (2005), Corporate Finance, 7e, McGraw-Hill.