Merger Analysis Smitty’s Home Repair Company, a regional hardware chain that spe
ID: 2740413 • 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)
THE ECONOMICALLY JUSTIFIABLE RATIONALES FOR MERGERS ARE SYNERGY AND TAX CONSEQUENCES. SYNERGY OCCURS WHEN THE VALUE OF THE COMBINED FIRM EXCEEDS THE SUM OF THE VALUES OF THE FIRMS TAKEN SEPARATELY. (IF SYNERGY EXISTS, THEN THE WHOLE IS GREATER THAN THE SUM OF THE PARTS, AND HENCE SYNERGY IS ALSO CALLED THE “2 + 2 = 5” EFFECT.)
A SYNERGISTIC MERGER CREATES VALUE THAT MUST BE APPORTIONED BETWEEN THE STOCKHOLDERS OF THE MERGING COMPANIES. SYNERGY CAN ARISE FROM FOUR SOURCES: (1) OPERATING ECONOMIES OF SCALE IN MANAGEMENT, PRODUCTION, MARKETING, OR DISTRIBUTION; (2) FINANCIAL ECONOMIES, WHICH COULD INCLUDE HIGHER DEBT CAPACITY, LOWER TRANSACTIONS COSTS, OR BETTER COVERAGE BY SECURITIES’ ANALYSTS THAT CAN LEAD TO HIGHER DEMAND AND, HENCE, HIGHER PRICES; (3) DIFFERENTIAL MANAGEMENT EFFICIENCY, WHICH IMPLIES THAT NEW MANAGEMENT CAN INCREASE THE VALUE OF A FIRM’S ASSETS; AND (4) INCREASED MARKET POWER DUE TO REDUCED COMPETITION. OPERATING AND FINANCIAL ECONOMIES ARE SOCIALLY DESIRABLE, AS ARE MERGERS THAT INCREASE MANAGERIAL EFFICIENCY, BUT MERGERS THAT REDUCE COMPETITION ARE BOTH UNDESIRABLE AND ILLEGAL.
ANOTHER VALID RATIONALE BEHIND MERGERS IS TAX CONSIDERATIONS. FOR EXAMPLE, A FIRM THAT IS HIGHLY PROFITABLE AND CONSEQUENTLY IN THE HIGHEST CORPORATE TAX BRACKET COULD ACQUIRE A COMPANY WITH LARGE ACCUMULATED TAX LOSSES, AND IMMEDIATELY USE THOSE LOSSES TO SHELTER ITS CURRENT AND FUTURE INCOME. WITHOUT THE MERGER, THE CARRY-FORWARDS MIGHT EVENTUALLY BE USED, BUT THEIR VALUE WOULD BE HIGHER IF USED NOW RATHER THAN IN THE FUTURE.
THE MOTIVES THAT ARE GENERALLY LESS SUPPORTABLE ON ECONOMIC GROUNDS ARE RISK REDUCTION, PURCHASE OF ASSETS AT BELOW REPLACEMENT COST, CONTROL, AND GLOBALIZATION. MANAGERS OFTEN STATE THAT DIVERSIFICATION HELPS TO STABILIZE A FIRM’S EARNINGS STREAM AND THUS REDUCES TOTAL RISK, AND HENCE BENEFITS SHAREHOLDERS. STABILIZATION OF EARNINGS IS CERTAINLY BENEFICIAL TO A FIRM’S EMPLOYEES, SUPPLIERS, CUSTOMERS, AND MANAGERS. HOWEVER, IF A STOCK INVESTOR IS CONCERNED ABOUT EARNINGS VARIABILITY, HE OR SHE CAN DIVERSIFY MORE EASILY THAN CAN THE FIRM. WHY SHOULD FIRM A AND FIRM B MERGE TO STABILIZE EARNINGS WHEN STOCKHOLDERS CAN MERELY PURCHASE BOTH STOCKS AND ACCOMPLISH THE SAME THING?
FURTHER, WE KNOW THAT WELL-DIVERSIFIED SHAREHOLDERS ARE MORE CONCERNED WITH A STOCK’S MARKET RISK THAN ITS STAND-ALONE RISK, AND HIGHER EARNINGS INSTABILITY DOES NOT NECESSARILY TRANSLATE INTO HIGHER MARKET RISK.
SOMETIMES A FIRM WILL BE TOUTED AS A POSSIBLE ACQUISITION CANDIDATE BECAUSE THE REPLACEMENT VALUE OF ITS ASSETS IS CONSIDERABLY HIGHER THAN ITS MARKET VALUE. FOR EXAMPLE, IN THE EARLY 1980S, OIL COMPANIES COULD ACQUIRE RESERVES MORE CHEAPLY BY BUYING OUT OTHER OIL COMPANIES THAN BY EXPLORATORY DRILLING. HOWEVER, THE VALUE OF AN ASSET STEMS FROM ITS EXPECTED CASH FLOWS, NOT FROM ITS COST. THUS, PAYING $1 MILLION FOR A SLIDE RULE PLANT THAT WOULD COST $2 MILLION TO BUILD FROM SCRATCH IS NOT A GOOD DEAL IF NO ONE USES SLIDE RULES.
IN RECENT YEARS, MANY HOSTILE TAKEOVERS HAVE OCCURRED. TO KEEP THEIR COMPANIES INDEPENDENT, AND ALSO TO PROTECT THEIR JOBS, MANAGERS SOMETIMES ENGINEER DEFENSIVE MERGERS WHICH MAKE THEIR FIRMS MORE DIFFICULT TO “DIGEST.” ALSO, SUCH DEFENSIVE MERGERS ARE USUALLY DEBT-FINANCED, WHICH MAKES IT HARDER FOR A POTENTIAL ACQUIRER TO USE DEBT FINANCING TO FINANCE THE ACQUISITION. IN GENERAL, DEFENSIVE MERGERS APPEAR TO BE DESIGNED MORE FOR THE BENEFIT OF MANAGERS THAN FOR THAT OF THE STOCKHOLDERS.
AN INCREASED DESIRE TO BECOME GLOBALIZED HAS RESULTED IN MANY MERGERS. TO MERGE JUST TO BECOME INTERNATIONAL IS NOT AN ECONOMICALLY JUSTIFIED REASON FOR A MERGER; HOWEVER, INCREASED GLOBALIZATION HAS LED TO INCREASED ECONOMIES OF SCALE. THUS, SYNERGISM OFTEN RESULTS--WHICH IS AN ECONOMICAL JUSTIFIABLE REASON FOR MERGERS. SYNERGY APPEARS TO BE THE REASON FOR THIS MERGER.
(B)
IN A FRIENDLY MERGER, THE MANAGEMENT OF ONE FIRM (THE ACQUIRER) AGREES TO BUY ANOTHER FIRM (THE TARGET). IN MOST CASES, THE ACTION IS INITIATED BY THE ACQUIRING FIRM, BUT IN SOME SITUATIONS THE TARGET MAY INITIATE THE MERGER. THE MANAGEMENTS OF BOTH FIRMS GET TOGETHER AND WORK OUT TERMS THAT THEY BELIEVE TO BE BENEFICIAL TO BOTH SETS OF SHAREHOLDERS. THEN THEY ISSUE STATEMENTS TO THEIR STOCKHOLDERS RECOMMENDING THAT THEY AGREE TO THE MERGER. OF COURSE, THE SHAREHOLDERS OF THE TARGET FIRM NORMALLY MUST VOTE ON THE MERGER, BUT MANAGEMENT’S SUPPORT GENERALLY ASSURES THAT THE VOTES WILL BE FAVORABLE.
IF A TARGET FIRM’S MANAGEMENT RESISTS THE MERGER, THEN THE ACQUIRING FIRM’S ADVANCES ARE SAID TO BE HOSTILE RATHER THAN FRIENDLY. IN THIS CASE, THE ACQUIRER, IF IT CHOOSES TO, MUST MAKE A DIRECT APPEAL TO THE TARGET FIRM’S SHAREHOLDERS. THIS TAKES THE FORM OF A TENDER OFFER, WHEREBY THE TARGET FIRM’S SHAREHOLDERS ARE ASKED TO “TENDER” THEIR SHARES TO THE ACQUIRING FIRM IN EXCHANGE FOR CASH, STOCK, BONDS, OR SOME COMBINATION OF THE THREE. IF 51 PERCENT OR MORE OF THE TARGET FIRM’S SHAREHOLDERS TENDER THEIR SHARES, THEN THE MERGER WILL BE COMPLETED OVER MANAGEMENT’S OBJECTION.
(C) THE EASIEST APPROACH HERE IS TO CREATE CASH FLOW STATEMENTS FOR THE H DIVISION, ASSUMING THAT THE ACQUISITION IS MADE (IN MILLIONS OF DOLLARS).
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/ADMIN. EXPENSES 4.5 6.0 7.5 9.0
INTEREST EXPENSE 3.0 4.5 4.5 6.0
EARNINGS BEFORE TAXES $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 NOTE THAT THESE STATEMENTS ARE IDENTICAL TO STANDARD CAPITAL BUDGETING CASH FLOW STATEMENTS EXCEPT THAT BOTH INTEREST EXPENSE AND RETENTIONS ARE INCLUDED IN MERGER ANALYSIS. IN STRAIGHT CAPITAL BUDGETING, ALL DEBT INVOLVED IS NEW DEBT THAT IS ISSUED TO FUND THE ASSET ADDITIONS. HENCE, THE DEBT INVOLVED ALL COSTS THE SAME, kd, AND THIS COST IS ACCOUNTED FOR BY DISCOUNTING THE CASH FLOWS AT THE FIRM’S WACC. HOWEVER, IN A MERGER THE ACQUIRING FIRM USUALLY BOTH ASSUMES THE EXISTING DEBT OF THE TARGET AND ISSUES NEW DEBT TO HELP FINANCE THE TAKEOVER. THUS, THE DEBT INVOLVED HAS DIFFERENT COSTS, AND HENCE CANNOT BE ACCOUNTED FOR AS A SINGLE COST IN THE WACC. THE EASIEST SOLUTION IS TO EXPLICITLY INCLUDE INTEREST EXPENSE IN THE CASH FLOW STATEMENT. IN REGARDS TO RETENTIONS, ALL OF THE CASH FLOWS FROM AN INDIVIDUAL PROJECT ARE AVAILABLE FOR USE THROUGHOUT THE FIRM, BUT SOME OF THE CASH FLOWS GENERATED BY AN ACQUISITION ARE GENERALLY RETAINED WITH THE NEW DIVISION TO HELP FINANCE ITS GROWTH. SINCE SUCH RETENTIONS ARE NOT AVAILABLE TO THE PARENT COMPANY FOR USE ELSEWHERE, THEY MUST BE DEDUCTED IN THE CASH FLOW STATEMENT.
WITH INTEREST EXPENSE AND RETENTIONS INCLUDED IN THE CASH FLOW STATEMENTS, THE CASH FLOWS ARE RESIDUALS THAT ARE AVAILABLE TO THE ACQUIRING FIRM’S EQUITY HOLDERS. SMITTY’S MANAGEMENT COULD PAY THESE OUT AS DIVIDENDS OR REINVEST THEM IN OTHER DIVISIONS OF THE FIRM, AS THEY SEE FIT.
(D) AS DISCUSSED ABOVE, THE CASH FLOWS ARE RESIDUALS, AND THEY BELONG TO THE ACQUIRING FIRM’S SHAREHOLDERS. SINCE INTEREST EXPENSE HAS ALREADY BEEN CONSIDERED, THE CASH FLOWS ARE RISKIER THAN THE TYPICAL CAPITAL BUDGETING CASH FLOWS, AND THEY MUST BE DISCOUNTED USING THE COST OF EQUITY RATHER THAN THE WACC. FURTHER, THE DISCOUNT RATE MUST REFLECT THE RISKINESS OF THE FLOWS, AND THESE CASH FLOWS HAVE HILL’S BUSINESS RISK, NOT SMITTY’S BUSINESS RISK. HOWEVER, THE MARKET RISK OF THE H DIVISION IS NOT THE SAME AS THE MARKET RISK OF HILL’S OPERATING INDEPENDENTLY, BECAUSE THE MERGER AFFECTS HILL’S LEVERAGE AND TAX RATE. SMITTY’S INVESTMENT BANKERS HAVE ESTIMATED THE H DIVISION’S BETA WILL BE 1.3 AFTER THE MERGER AND THE ADDITIONAL LEVERAGE HAS BEEN EMPLOYED.
TO OBTAIN THE REQUIRED RATE OF RETURN ON EQUITY, NOTE THAT kRF= 9% AND RPM= 4%. THUS, THE H DIVISION’S REQUIRED RATE OF RETURN ON EQUITY, WHICH IS THE APPROPRIATE DISCOUNT RATE TO APPLY TO THE MERGER CASH FLOWS, IS 14.2 %
ks(H DIVISION)= kRF+ (kM- kRF)bH DIVISION
= 9% + (4%)1.3 = 14.2%.
(E) THE 2018 CASH FLOW IS $17.1 MILLION, AND IT IS EXPECTED TO GROW AT A 6 PERCENT CONSTANT GROWTH RATE IN 2019 AND BEYOND. WITH A CONSTANT GROWTH RATE, THE GORDON MODEL CAN BE USED TO VALUE THE CASH FLOWS BEYOND 2018
TERMINAL VALUE = 2018 CASH FLOW (1+g) ks - g
= $17.1(1.06) 0.142-0.06
= $221.0 MILLION.
ADDING THE TERMINAL VALUE, THE NET CASH FLOW STREAM LOOKS LIKE THIS (IN MILLIONS OF DOLLARS):
2015 2016 2017 2018
ANNUAL CASH FLOW $9.9 $7.8 $13.8 $ 17.1
TERMINAL VALUE 221.0
NET CASH FLOW $9.9 $7.8 $13.8 $238.1
NOW, THE VALUE OF HILL’S TO SMITTY’S IS THE PRESENT VALUE OF THIS STREAM, DISCOUNTED AT 14.2 PERCENT, OR $163.9 MILLION.
IF ANOTHER FIRM WERE VALUING HILL’S, THEY WOULD PROBABLY OBTAIN AN ESTIMATE DIFFERENT FROM $163.9 MILLION. MOST IMPORTANT, THE SYNERGIES INVOLVED WOULD LIKELY BE DIFFERENT, AND HENCE THE CASH FLOW ESTIMATES WOULD DIFFER. ALSO, ANOTHER POTENTIAL ACQUIRER MIGHT USE DIFFERENT FINANCING, OR HAVE A DIFFERENT TAX RATE, AND HENCE ESTIMATE A DIFFERENT DISCOUNT RATE.
(F) WITH A CURRENT PRICE OF $9 PER SHARE AND 10 MILLION SHARES OUTSTANDING, HILL’S CURRENT MARKET VALUE IS $9(10) = $90 MILLION. SINCE HILL’S EXPECTED VALUE TO SMITTY’S IS $163.9 MILLION, IT APPEARS THAT THE MERGER WOULD BE BENEFICIAL TO BOTH SETS OF STOCKHOLDERS. THE DIFFERENCE, $163.9 - $90.0 = $73.9 MILLION, IS THE ADDED VALUE TO BE APPORTIONED BETWEEN THE STOCKHOLDERS OF BOTH FIRMS.
THE OFFERING RANGE IS FROM $9 PER SHARE TO $163.9/10 = $16.39 PER SHARE. AT $9, ALL OF THE BENEFIT OF THE MERGER GOES TO SMITTY’S SHAREHOLDERS, WHILE AT $16.39, ALL OF THE VALUE CREATED GOES TO HILL’S SHAREHOLDERS. IF SMITTY’S OFFERS MORE THAN $16.39 PER SHARE, THEN WEALTH WOULD BE TRANSFERRED FROM SMITTY’S STOCKHOLDERS TO HILL’S STOCKHOLDERS. AS TO THE ACTUAL OFFERING PRICE, SMITTY’S SHOULD MAKE THE OFFER AS LOW AS POSSIBLE, YET ACCEPTABLE TO HILL’S SHAREHOLDERS. A LOW INITIAL OFFER, SAY $9.50 PER SHARE, WOULD PROBABLY BE REJECTED AND THE EFFORT WASTED. FURTHER, THE OFFER MAY INFLUENCE OTHER POTENTIAL SUITORS TO CONSIDER HILL’S, AND THEY COULD END UP OUTBIDDING SMITTY’S. CONVERSELY, A HIGH PRICE, SAY $16, PASSES ALMOST ALL OF THE GAIN TO HILL’S STOCKHOLDERS, AND SMITTY’S MANAGERS SHOULD RETAIN AS MUCH OF THE SYNERGISTIC VALUE AS POSSIBLE FOR THEIR OWN SHAREHOLDERS. NOTE THAT THIS DISCUSSION ASSUMES THAT HILL’S $9 PRICE IS A “FAIR,” EQUILIBRIUM VALUE IN THE ABSENCE OF A MERGER. SINCE THE STOCK TRADES INFREQUENTLY, THE $9 PRICE MAY NOT REPRESENT A FAIR MINIMUM PRICE. HILL’S MANAGEMENT SHOULD MAKE AN EVALUATION (OR HIRE SOMEONE TO MAKE THE EVALUATION) OF A FAIR PRICE AND USE THIS INFORMATION IN ITS NEGOTIATIONS WITH SMITTY’S.
(G)
THE INVESTMENT BANKING COMMUNITY IS INVOLVED WITH MERGERS IN A NUMBER OF WAYS. SEVERAL OF THESE ACTIVITIES ARE: (1) HELPING TO ARRANGE MERGERS, (2) AIDING TARGET COMPANIES IN DEVELOPING AND IMPLEMENTING DEFENSIVE TACTICS, (3) HELPING TO VALUE TARGET COMPANIES, (4) HELPING TO FINANCE MERGERS, AND (5) RISK ARBITRAGE SPECULATING IN THE STOCKS OF COMPANIES THAT ARE LIKELY TAKEOVER TARGETS.