Mergers And Acquisitions

University of Durham

Mergers and Acquisitions Summative Assignment By

Samuel Tedjasukmana

April 2007

I. Introduction

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Targeting private firms seems to be the current trend in mergers and acquisitions. In the US alone, the year 1996 saw 84% increase of takeover deals involving private firms as the target compared to the previous year (Ang and Kohers, 2001). The total value of these transactions reached £40 billion. This paper seeks to investigate the issues surrounding mergers and acquisitions, both in general and specifically of a privately owned business, as the following: estimating the value of a privately owned business, determining the value of an acquisition deal settlement, how to eliminate a competitive bidder, and how asymmetric information influences company’s corporate financing policies, including those involving merger. These issues are observed from the acquirer’s point of view, which in this study is London Globe. The target company is Murdoch Incorporated, and for the purpose of valuation, McIntosh Corporation (a public company similar to Murdoch in terms of industry) is used as a comparable company. London Globe is a construction company, and has been blessed by the current boom in the housing market. The industry classification for this company is assumed as Building – residential and commercial (see appendix for details). Murdoch the target company has the core business of gas pipeline construction and related equipment, which is similar to a public company, McIntosh Corporation.

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II. The value of the target company and the maximum price of the acquisition Murdoch Incorporated (Murdoch) is a privately owned business. It does mean that in the process of searching for its value, some basic principles of comparable method of valuation should be used. The following analysis uses the information gathered from the comparable public company, which is the McIntosh Corporation (McIntosh). Shares outstanding Share price Market value of equity Debt β Tax rate Risk-free rate Risk premium Table 1. Preliminary review

Murdoch 25 millions £500 million 35% 8% 8%

McIntosh 30 millions £25 £750 million £80 million 1.20 35% 8% 8%

There are three main components of valuation: the weighted average cost of capital (WACC), the free cash flow (FCF), and the expected growth of cash flow items (Damodaran, 2002). The first step in valuing Murdoch would be to determine the cost of equity – as a part of WACC calculation – by using McIntosh’s data, both firmspecific as well as its market information. The basic assumption underlying this calculation is that both companies are within the same industry, which also means being in the same market. Therefore, both of them will have the same risk-free rate, corporate tax rate, and utterly the same risk premium. Finally, to estimate the β for Murdoch, the calculation should assume that Murdoch’s β will eventually converge to its industry average β (using McIntosh’s β as proxy) by the time it goes public (Damodaran, 2002). The detailed calculation process and results are presented in the following table.

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β (levered) β (un-levered) β (private entity)

McIntosh

Murdoch

1.20 1.12 -

1.41

Cost of equity

19.28%

Cost of debt

8.85%

Debt-equity ratio B/S = 0.4 (target)

NI £200m  int erest   £50m  £357.69m 1T   1  0.35  EBIT £357.69m CR    7.15  Bond rating A  Cost of borrowing = 0.85% Interest £50m EBIT 

kd  kb  1  T   8.85%  1  0.35   5.75% 15.42%

£200.00m £357.69m £40.00m £317.69m

Value Equity value Equity value/share

above the risk-free rate1

kb  R f  spread  8%  0.85%  8.85%

5.75%

WACC Net Income (projected) EBIT Contingent loss EBIT (corrected) EBIT (1-tax) Investment FCF Expected growth (g)

B   p   u  1   1  T      p  1.12  1   1  0.35   0.4   1.41 S  ke  R f    Rm  R f   ke  8%  1.41 8%   ke  19.28%

CR = Interest coverage ratio Cost of debt after tax

Details l 1.20 u   u    u  1.12  1 B1T    1  £80m  1  0.35       S £750 m

WACC  ke

£206.50m £50.00m £156.50m 2% £1,177.67m £677.67m £27.11

Value 

S B 1 0.4  kd  19.28%  5.75%  15.42% BS BS 1.4 1.4

FCF  1  g  £156.50m  100%  2%    £1,174.61m WACC  g 15.59%  2%

Equity  Value  Debt  £1,177.67 m  £500m  £677.67 m EV / share 

EV £677.67 m   £27.11 shares 25m

Table 2. Calculation for Murdoch’s (target company) value 1

See appendix for more details on the synthetic bond rates

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Comments on results Since London Globe is a public company, the deal of acquiring Murdoch is not a private deal. In that sense, the calculation of Murdoch’s cost of capital would have been different if the deal was private. This very much affects the assumption of what borrowing rate should be used. Given that Murdoch is a private business, it cannot generate debt from the market. Instead, it raises debt from bank loans. The interest rate for this loan is 10 percent for Murdoch [50m/500m x 100%]. This rate does not resemble Murdoch’s credit rating in the market. Since the nature of the deal is public, the calculation should use the appropriate rate, which is the bond rate (Damodaran, 2002). Taking into the account the interest coverage ratio, provided as the company’s information, the bond rate can be estimated to reflect the company’s credit rating in the market. Moreover, the fact that Murdoch, with certainty will incur contingent loss, i.e. lawsuit liability amounting £40 million, and the event is assumed will take place after the acquisition; London Globe is entitled to get a tax deduction (Maples, 2003). London Globe saves £14 million worth of tax due to the inclusion of lawsuit liability (contingent loss) in the valuation of Murdoch. To convert the information of net income into earnings before interest and tax (EBIT), the fixed charge of interest should be included as the standard accounting procedure. However in the next step of determining the FCF, the direct taxation of EBIT is justified (Damodaran, 1997). The value of FCF estimated is assumed to grow in perpetuity, which is why the growth rate becomes a multiplying factor of FCF.

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Reliability of the method used, and other methods could have been used Comparable method used in the calculation carries some limitations. Since only one company used as a comparison to estimate Murdoch’s cost of equity, assuming they are in the same field of business, it raises a concern over the estimation’s reliability. Moreover, the danger of misestimating becomes more apparent when it assumes McIntosh as the proxy for the industry average. Such method, namely comparable company method, has less accuracy than the comparable transaction or comparable industry transaction method (Kaplan and Ruback, 1995). Either method would give more accurate results in estimating Murdoch’s cost of capital at market rate, since they consider information from several – or all – companies within the industry. The discounted cash flow method (DCF) allows more in-depth analysis in valuing a firm. However, given the nature of Murdoch as a private business, it will be quite difficult to find information conforming to the market’s standards, e.g. LSEconforming financial statement, future investment plan, a change in the management, etc, to perform such analysis. The maximum price of the acquisition bid The maximum price London Globe should pay for each share of Murdoch is simply the equity value per shares outstanding, which is £27.11/share (as seen on the table). III. Finalising the deal As London Globe figured out the value of Murdoch, then the next is to know for what price the deal is going to be sealed (assuming there is no other bidder takes part).

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The premiums paid to a privately owned business is higher than the average publicowned ones (Ang and Kohers, 2001). Especially for cash as the method of payment, shareholders of private firms have received premium in the amount of 2.2 times their book value of holdings, or in other words the offer-to-book ratio is 2.2 (Ang and Kohers, 2001). For the publicly traded target companies, Ang and Kohers find the ratio figure as 1.9 on average. Given that the equity value is £27.11/share, and the deal will be in cash, thus according to the offer-to-book ratio of 2.2, the deal might be settled at £27.11 times 2.2, amounting £59.63/share. However, since the calculation has estimated the equity value of Murdoch at the market rate, not the book value, the usage of such ratio can be misleading. Another fact, given that the average premium paid in an acquisition deal for a public company is about 30 to 40 percent from the market value of equity of the target (Weston et al, 2004), this ratio may well be the most relevant in Murdoch case. The problem is, Murdoch is a private firm. It is necessary to estimate the proper premium ratio that reflects offer-to-market-value ratio for private firms. As aforementioned, there are two ratios to be observed: the offer-to-book for private firms at 2.2; and the offer-to-market for public companies at 1.35 (average between 30 and 40 percent of premium rate). Following the argument that private firms receive more premium than the average public companies (Ang and Kohers, 2001), then the offer-to-market for private firms, in consistency will also be higher than that of public companies. Taking the average of both 2.2 and 1.35, the number will be at 1.8. Consider this as the estimation of offer-to-market ratio for private firms gives the figure of £27.11 x 1.8 = £48.79/share (£1.22 billion) as the final deal value in this

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acquisition. In theoretical sense, this means that London Globe will have to pay more than it should. Since the synergy value has been included the valuation of Murdoch, this excess premium will to some extent degrade the value of London Globe itself. In reality, the case for the acquisition of private firms involves very high premiums. The reason being is that the shareholders of private firms have stronger bargaining power due to the very low likelihood of the agency cost problem to occur (Ang and Kohers, 2001). Or in other words, since the shareholders are actually in the management board, which means they know exactly what the business is all about and its prospects in the future, it requires very high premium to acquire a private firm. IV. Eliminating competitive bidder The first bidder (FB), which is London Globe, will have to make a bidding strategy against the second bidder (SB) who is assumed to have valuated Murdoch and their results on synergy ranging uniformly between -50 and 200 from FB’s valuation of the maximum price. The maximum price that FB has calculated is £677.77 million. The next step is to determine at what price that FB can deter the competition from SB, i.e. determining the pre-emptive bid. According to Fishman model (1988), we can formulate the preemptive bid by using SB’s valuation range [l, h] ~ [-50, 200], the cost of acquisition by SB, and the market value of the target. For such purpose, the following assumptions are used:



The market equity value of Murdoch is £677.77 million, since SB has assumed the synergy valuation by FB as the fair equity market value of Murdoch.

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•

The cost of acquiring Murdoch by SB is assumed 5% from the market value of Murdoch.

The calculation uses the following formula (Fishman, 1988):

vo2  2vo l  h 2 p(r )   3c2 2 h  l  Detailed process of the calculation is presented in the following table. Variable input h=200 l=-50 Vo= £677.77m C2= 5%*£677.77m = £33.88m

Calculation steps p(r ) 

vo2  2vol  h2  3c2  2 h  l 

p(r ) 

£677.67 m 2  2  £677.67 m  (50)  2002  3  £33.88m  £1, 032.35m 2  200  50 

Table 6. Pre-emptive bid by Fishman model

Pre-emptive bid value: £1,032.35m, or £41.29/share. Bidding strategy Fishman model (1988) provides a straightforward look at calculating the pre-emptive bid. However, this model depends very heavily on the assumption of the cost of acquisition by the SB. The 5% cost stated in the calculation is just an illustration, and might be the case that it is not accurately estimated. This cost may comprise of the investment bank fee for investigation, legal consulting fee, insider information attainment, etc, which plays a very crucial role in determining the gain from the acquisition deal (Fishman, 1988). One point to look at as well is that when there is a competing bidder for an acquisition, the bidding can turn out to be costly. Even though London Globe has realised the amount of cash they have to generate to prevent competition, it might be the case that Murdoch is not worth the efforts. Thus, London Globe has to formulate a bidding strategy in order to win the bid as efficiently as possible. One way to do is

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to put the first bid at a low value. The first bid by FB is the source of valuation signalling for the SB (Hirshleifer, 1995). SB usually determines the minimum threshold of FB’s valuation by looking at their first bid value. From that value, SB will begin to investigate and assume the initial bid value to compete with FB. In general, when there is no significant gap between two bids (no far higher offer compared to the other), the deal will be closed at relatively low price (Hirshleifer, 1995). At least, London Globe has figured out (at 5% cost) that the pre-emptive bid will be, at the most, £41.29/share (£1,032.35m). The bidding then can start from the initial point of £27.11/share through £41.29/share. V. External vs. internal equity financing Capital Structure Equity London Globe2 Murdoch Generate £50m cash Total equity Debt London Globe Murdoch Total debt Debt-equity ratio Beta un-levered Beta levered Cost of equity Cost of debt after tax WACC

External financing

Internal financing

£4,000.00m £677.67m £4,677.67m £50.00m £4,727.67m

£4,000.00m £677.67m £4,677.67m £4,677.67m

£150.00m £500.00m £650.00m

£150.00m £500.00m £650.00m

0.137 1.21 1.32 18.54% 5.20% 16.93%

0.138 1.21 1.32 18.55% 5.20% 16.92%

Table 7. Capital structure between external and internal equity financing

To finance Murdoch’s plant restructuring, or in other words pledging in a new investment, London Globe should always consider the financing method suitable for the feasible capital structure of the company. Table 7 presents how capital structure will look like using two different financing strategies. The first one is the external

2

London Globe has 50 million shares outstanding at current market price of £80/share.

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equity financing and the other internal one. External equity financing involves issuing either common stocks or warrants (Damodaran, 1997); whilst the internal one reserves cash from the retained earnings the company has produced. Suppose that the un-levered beta of the combined firms (between London Globe and Murdoch) is known3, the cost of capital from both scenarios can be observed. The figures showed do not really reflect any substantial difference between the two costs of capital. This is because the amount of cash London Globe has to generate is immaterial compared to the combined equity value, i.e. £50 million compared to more than £4.5 billion. Nonetheless, the observable point on table 7 is that the cost of capital for internal equity financing is lower than that of external equity financing. The probable reason for this is that the debt-to-equity ratio for the combined firm has not been the optimal debt-to-equity ratio (Damodaran, 1997). Or in other words, the combined firm is under-levered, because if it was over-levered, higher debt-equity would result in higher cost of capital (Damodaran, 1997). In such condition then, it is better for London Globe to finance the investment project with internal equity financing rather than external one. In addition, given the fact that London Globe has been blessed by the current booming in the housing market, there is no immediate necessity to capitalise more in equity. The role of asymmetric information on merger and external equity financing

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To estimate the un-levered beta of the combined firm, the industry average un-levered beta of building industry in Europe, specifically the residential and commercial building industry, is used. This beta is 1.30. Taking the average between Murdoch’s un-levered beta of 1.12 and London Globe’s 1.30 gets the combined un-levered and levered beta of 1.21 and 1.32 respectively (see appendix for more details).

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The external equity financing is a corporate capital structure policy upon an investment opportunity. A company, from its own rational consideration may go for this opportunity or leave it. In the case for a public company, such decision on whether to take on the opportunity is observed by the market. The market is digging the information about a public company’s investment policies in order to price its stocks efficiently based on the information obtained (Myers and Majluf, 1984). Thus, asymmetric information is a condition when the managers of the company know something that the market does not. For example, in the case of external equity financing let’s say a company sees an investment opportunity and need to finance it with external equity financing. The project valuation figures show this as a promising project to take on. The stockholders, however, are not sure about the cash that can be generated from a further issue of stocks, since such issue might be sold at lower price and thus lower the value of their holdings. The management board might pull off and abandon this investment opportunity to retain the stockholder’s wealth. The market, on the other hand, does not know about this and perceive that no new issues of stocks as good news (asymmetric information). In fact, missing out a profitable investment opportunity decreases the value of the company and if the market knows this, it will bring the stock price down (Myers and Majluf, 1984). On the contrary, if the company undertakes the external financing for this investment the market does not know how feasible this project will be, and might reassess the level of corporate risk, especially when the market knows that the company is undertaking a negative NPV investment project for instance.

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From the argument of asymmetric information, it might be the case that the company will prefer internal equity financing by rearranging its dividend payout ratio as an alternative to external equity financing (Myers, 1984). Furthermore, as aforementioned, in the case of London Globe and Murdoch as a combined entity, it has under-levered circumstances, which makes its financing slack huge enough to carry more debt (Damodaran, 1997). Thus, even if the company does not posses enough internal resource to finance any investment, it still has the option of optimising its leverage ratio by undertaking debt financing, as illustrated below. Capital Structure Equity London Globe Murdoch

External financing

Debt financing

Generate £50m cash Total equity

£4,000.00m £677.67m £4,677.67m £50.00m £4,727.67m

£4,000.00m £677.67m £4,677.67m £4,677.67m

Debt London Globe Murdoch Generate £50m cash Total debt

£150.00m £500.00m £650.00m

£150.00m £500.00m £20.00m £700.00m

Debt-equity ratio 0.137 Beta un-levered 1.21 Beta levered 1.32 Cost of equity 18.54% Cost of debt after tax 5.20% WACC 16.93% Table 7. Capital structure between external equity and debt financing

0.149 1.21 1.33 18.62% 5.20% 16.87%

The weighted average cost of capital (WACC) for debt financing is lower than that of external equity financing scenario. This proves the point that external financing, given the asymmetric information effect, is something that any company wants to avoid. Let’s make the circumstances even more intriguing. If a company has little financing slack and retained earning, which means internal equity and debt financing are out of the question, merger will be the answer to increase value rather than issuing new

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stocks (Myers and Majluf, 1984). A merger can combine both companies’ financing slack and internal equity, avoiding them to undertake external equity financing. VI. Concluding remarks The total value of Murdoch is £1,177.67 million with £677.67 (£27.11/share) of which being the market value estimate of equity as well as the maximum price for London Globe to pay for the acquisition. It seems though that London Globe has to spend £1.22 billion (£48.79/share) to close the deal assuming there is no other bidder, given the excess premium needed to acquire a private company. To prevent a competing bidder from acquiring Murdoch, London Globe assumes the pre-emptive bid to exceed £1.03 billion (£41.29/share). Lastly, in choosing the method of financing the plan-restructuring, London Globe should pursue either internal equity or debt financing given the asymmetric information problem. Appendix For smaller and riskier firms If interest coverage ratio is greater than ≤ to Rating is Spread is -100000 0.499999 D 20.00% 0.5 0.799999 C 12.00% 0.8 1.249999 CC 10.00% 1.25 1.499999 CCC 8.00% 1.5 1.999999 B6.00% 2 2.499999 B 4.00% 2.5 2.999999 B+ 3.25% 3 3.499999 BB 2.50% 3.5 3.9999999 BB+ 2.00% 4 4.499999 BBB 1.50% 4.5 5.999999 A1.00% 6 7.499999 A 0.85% 7.5 9.499999 A+ 0.70% 9.5 12.499999 AA 0.50% 12.5 100000 AAA 0.35% Synthetic bond rates table using the interest coverage ratio Based on S&P 500 bond rating classes ©2007 Aswath Damodaran, Stern Business School, New York University http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

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Industry sector

Firms

Beta

D/E

Tax

U-Beta

Cash/ Value 3.45% 4.41% 3.04% 3.79% 7.18% 11.92% 4.79%

Bldg Prod-Air&Heating 8 0.70 14.27% 25.23% 0.64 Bldg Prod-Cement/Aggreg 32 1.08 38.41% 24.43% 0.84 Bldg Prod-Doors&Windows 3 0.53 21.40% 24.83% 0.45 Bldg Prod-Wood 7 1.03 35.53% 34.58% 0.84 Bldg&Construct Prod-Misc 31 0.91 17.23% 28.40% 0.81 Bldg-Mobil Home/Mfd Hous 6 0.67 12.27% 27.01% 0.62 Bldg-Residential/Commer 20 1.34 11.45% 25.45% 1.24 Average industry financial data (abridged version) Based on European industry average ©2007 Aswath Damodaran, Stern Business School, New York University http://www.stern.nyu.edu/~adamodar/pc/datasets/betaEurope.xls

U-Beta Cash 0.66 0.88 0.47 0.87 0.87 0.70 1.30

References

Ang, James; Kohers, Ninon, 2001. The takeover market for privately held companies: the US experience. Cambridge Journal of Economics, volume 25, page 723-748 Damodaran, Aswath, 2002. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (2/e). Chapter 24: Valuing Private Firms. John Wiley & Sons, Inc Damodaran, Aswath, 1997. Corporate Finance: Theory and Practice, relevant chapters, John Wiley & Sons Inc Fishman, Michael J., 1988. A Theory of Pre-emptive Takeover Bidding. The RAND Journal of Economics, volume 19, number 1, page 88-101 Hirshleifer, David, 1995. Mergers and Acquisitions: Strategic and Informational Issues. Chapter 26 in Jarrow, R.A., Maksimovic, V., Ziemba, W.T.; Handbooks in Operations Research and Management Science Volume 9, Elsevier BV Kaplan, Steven N., Ruback, Richard S., 1995. The Valuation of Cash Flow Forecasts: An Empirical Analysis. The Journal of Finance, volume 50, number 4, page 10591093Maples, Larry, 2003. Taxation on Pending Claims. Journal of Accountancy, May 2003 edition, page 31-37 Myers, Stewart C., 1984. The Capital Structure Puzzle. The Journal of Finance, volume 39, number 3, page 575-592 Myers, Stewart C., Majluf, Nicholas S., 1984. Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have. National Bureau of Economic Research (NBER) Working Paper Series, Working Paper No. 1396 Weston, J.F., Mitchell, Mark L., Mulherin, J.H., 2004. Takeovers, Restructuring, and Corporate Governance (4/e). Chapter 9: Alternative Approach to Valuation. Pearson Education

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