Merger Analysis Smitty’s Home Repair Company, a regional hardware chain that spe
ID: 2739723 • Letter: M
Question
Merger Analysis
Smitty’s Home Repair Company, a regional hardware chain that specializes in do-it-yourself materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Linda Wade, Smitty’s treasurer and your boss, has been asked to place a value on a potential target, Hill’s Hardware, a small chain that operates in an adjacent state, and she has enlisted your help.
Table 1 indicates Wade’s estimates of Hill’s earnings potential if it comes under Smitty’s management (in millions of dollars). The interest expense listed here includes the interest (1) on Hill’s existing debt,(2) on new debt that Smitty’s would issue to help finance the acquisition, and (3) on new debt expected to be issued over time to help finance expansion within the new “H division,” the code name given to the target firm. The retentions represent earnings that will be reinvested within the H division to help finance its growth.
Hill’s Hardware currently uses 40% debt financing, and it pays federal-plus-state taxes at a 30% rate. Security analysts estimate Hill’s beta to be 1.2. If the acquisition were to take place, Smitty’s would increase Hill’s debt ratio to 50%, which would increase Hill’s beta to 1.3. Further, because Smitty’s is highly profitable, taxes on the consolidated firm would be 40%. Wade realizes that Hill’s Hardware also generates depreciation cash flows, but she believes that these funds would have to be reinvested within the division to replace worn-out equipment.
Wade estimates the risk-free rate to be 9% and the market risk premium to be 4%. She also estimates that cash flows after 2018 will grow at a constant rate of 6%. Smitty’s management is new to the merger game, so Wade has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Wade has developed the following questions, which you must answer and then defend to Smitty’s board.
A. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, and (5) synergy. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.
B. Briefly describe the differences between a hostile merger and a friendly merger.
C. Use the data developed in Table 1 to construct the H division’s cash flow statements for 2015 through 2018. Why is interest expense deducted in merger cash flow statements, whereas it is not normally deducted in a capital budgeting cash flow analysis? Why are earnings retentions deducted in the cash flow statement?
D. Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c? What is your actual estimate of this discount rate?
E. What is the estimated continuing value of the acquisition; that is, what is the estimated value of the H division’s cash flows beyond 2018? What is Hill’s value to Smitty’s? Suppose another firm were evaluating Hill’s as an acquisition candidate. Would it obtain the same value? Explain.
F. Assume that Hill’s has 10 million shares outstanding. These shares are traded relatively infrequently, but the last trade, made several weeks ago, was at a price of $9 per share. Should Smitty’s make an offer for Hill’s? If so, how much should it offer per share?
G. What merger-related activities are undertaken by investment bankers?
TABLE 1
Estimates of Hill’s Hardware Data for Merger Analysis
2015
2016
2017
2018
Net sales
$60.00
$90.00
$112.50
$127.50
Cost of goods sold (60%)
36
54
67.5
76.5
Selling/administrative expense
4.5
6
7.5
9
Interest expense
3
4.5
4.5
6
Necessary retained earnings
0
7.5
6
4.5
TABLE 1
Estimates of Hill’s Hardware Data for Merger Analysis
2015
2016
2017
2018
Net sales
$60.00
$90.00
$112.50
$127.50
Cost of goods sold (60%)
36
54
67.5
76.5
Selling/administrative expense
4.5
6
7.5
9
Interest expense
3
4.5
4.5
6
Necessary retained earnings
0
7.5
6
4.5
Explanation / Answer
a. Economically justifiable reasons: Synergy: Value of the whole exceeds sum of the parts. Could arise from: Operating economies Financial economies Differential management efficiency Taxes (use accumulated losses) Break-up value: Assets would be more valuable if broken up and sold to other companies. Questionable reasons for mergers: Diversification Purchase of assets at below replacement cost Acquire other firms to increase size, thus making it more difficult to be acquired b. 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, try to get 51% to tender their shares. Often, mergers that start out hostile end up as friendly, when offer price is raised. c. 2015 2016 2017 2018 Net sales $ 60.0 $ 90.0 $ 112.5 $ 127.5 Cost of goods sold (60%) 36.0 54.0 67.5 76.5 Selling/administrative expense 4.5 6.0 7.5 9.0 Interest expense 3.0 4.5 4.5 6.0 EBT $ 16.5 $ 25.5 $ 33.0 $ 36.0 Taxes ( 40% ) 6.6 10.2 13.2 14.4 Net Income $ 9.9 $ 15.3 $ 19.8 $ 21.6 Retentions 0.0 7.5 6.0 4.5 Cash Flow $ 9.9 $ 7.8 $ 13.8 $ 17.1 d. Estimated cash flows are residuals that belong to the shareholders of the acquiring firm. They are riskier than the typical capital budgeting cash flows, because including fixed interest charges increases the volatility. Because the cash flows are equity flows, they should be discounted using a cost of equity rather than an overall cost of capital. Note that the cash flows reflect the target’s business risk, not the acquiring company’s. However, if the merger will affect the target’s leverage and tax rate, then it will affect its financial risk. ks(Target) = kRF + (kM - kRF) bTarget ks(Target) = 9% + 4% X 1.3 ks(Target) = 14.2% e. Horizon Value = (2018 Cash Flow)(1+g) 2015 2016 2017 2018 Ks - g Beta = 1.3 Net sales $ 60.0 $ 90.0 $ 112.5 $ 127.5 Tax Rate = 40% Cost of goods sold (60%) 36.0 54.0 67.5 76.5 Horizon Value = $ 221.0 million Ks = 14.2% Selling/administrative expense 4.5 6.0 7.5 9.0 Interest expense 3.0 4.5 4.5 6.0 EBT $ 16.5 $ 25.5 $ 33.0 $ 36.0 Annual Cash Flow $ 9.9 $ 7.8 $ 13.8 $ 17.1 Taxes ( 40% ) 6.6 10.2 13.2 14.4 Terminal Value $ 221.0 Net Income $ 9.9 $ 15.3 $ 19.8 $ 21.6 Net Cash Flow $ 9.9 $ 7.8 $ 13.8 $ 238.1 Retentions 0.0 7.5 6.0 4.5 Cash Flow $ 9.9 $ 7.8 $ 13.8 $ 17.1 Value = $ 163.9 million Would another potential acquirer obtain the same value? No. The cash flow estimates would be different, both due to forecasting inaccuracies and to differential synergies. Further, a different beta estimate, financing mix, or tax rate would change the discount rate. Note: Change the shaded cells above ( beta or tax rate ) to see the change in value f. Estimated Value of Target = $ 163.90 Targets Current Value = $ 90.00 10 million share x $9/share Merger Premium = $ 73.90 Presumably, the target’s value is increased by $73.9 million due to merger synergies, although realizing such synergies has been problematic in many mergers. The offer could range from $9 to $163.9/10 = $16.39 per share. At $9, all merger benefits would go to the acquiring firm’s shareholders. At $16.39, all value added would go to the target firm’s shareholders. g) 2015 EPS = $ 9.90 Million 2016 EPS = $ 15.30 Million $ 25.20 Million Average = $ 12.60 Million 12 x Avg. EPS = $ 151.20 14 x Avg. EPS = $ 176.40