Corporate Finance - Cfa Level Ii

Front 1

Investment outlay

Back 1

for a new project = fixed capital investments (land + depreciable assets) + net working capital investment (current assets – current liabilities)

for a replacement project = FCInv + NWCInv – Sal0 + T(Sal0 – B0), where Sal0 could be termed the current market value of an asset

Front 2

After-tax operating CFs over a projects life

Back 2

= operating sales less expenses less depreciation less taxes + add back depreciation for annual after-tax operating cash flow

If a replacement project – make sure to apply incremental sales, costs, and depreciation to annual CF calculation, not just the new CFs

Front 3

Terminal Year after-tax non-operating CF

Back 3

First determine the salvage value of the fixed investments (what they are sold for) less the remaining book value (what hasn’t been or wasn’t depreciated yet) = gain on sale

Tax the gain on sale + recovered initial working capital investment

TNOCF = SalT + NWCInc – T(SalT – BT) – here BT may be termed “accounting salvage value”

If a replacement project, SalT must be the incremental salvage value between the old and new asset, not just the salvage value of the new asset

Front 4

Effects of inflation on capital budget analysis

Back 4

Must determine whether to use nominal cash flows and the nominal discount rate or real cash flows and the real discount rate – cannot mix and match

Inflation reduces the value of depreciation tax savings, thereby essentially shifting wealth from the taxpayer to the government

Inflation reduces the value of fixed payments to bondholders – when bonds are issued, bondholders pay a price with embedded inflation expectations – if inflation is higher than expected, then the payments to the bondholder are lower than expected, thereby shifting wealth from the bondholders to the issuing corporations

Inflation will have a varying impact on revenues and costs, affecting annual after-tax operating cash flows

Front 5

Least common multiple of lives approach

Back 5

Used to make a decision among mutually exclusive projects with unequal lives

Extend the time horizon of each project until they match, i.e. the least common multiple of 2 and 3 is 6 years (2 is replicated 3x; 3 is 2x) with each repeated "initial" outlay occurring in conjunction with the final year cash flow

Front 6

Equivalent annual annuity (EAA) approach

Back 6

Used to make a decision among mutually exclusive projects with unequal lives

Find the PV of all cash flows for an investment and then determine the annuity payment (PMT) over the specified time horizon; or stated differently, find the annuity payment that is equal to NPV and pick the higher annuity

Front 7

Capital rationing

Back 7

when a company’s budget has a size constraint

Optimize your budget with only positive NPV projects – determine the optimal NPV based on needed outlay within a restricted budget

Use PI to determine the best projects when budget constraints bring outlay into the analysis

PI = PV of future cash flows / Initial investment

Violate the NPV rule, if budget constraints limit the company’s selection – go with the next best

Front 8

Sensitivity Analysis

Back 8

calculates the effect on NPV of changes in one input variable at a time

Front 9

Scenario Analysis

Back 9

creates scenarios that consist of changes in several of the input variables and calculates NPV for each scenario (typically three scenarios are done –bear, base, bull)

Front 10

Monte Carlo simulation

Back 10

where an analyst can assume several variables to be stochastic, following their own probability distributions, determining distributions for NPV and IRR on high volume of potential outcomes

Front 11

CAPM "basics" equation =

Back 11

systematic risk (market risk or beta) + unsystematic risk (non-market risk that can be diversified away)

Front 12

SML (security market line)

Back 12

expresses the asset’s required rate of return as a function of Beta

i. Ri = RFR + Beta * (Market Risk Premium) where the MRP = E(R) - RFR (this is CAPM)

ii. Diversified investors can demand a risk premium for systematic risk, but not unsystematic risk

iii. Should use project betas as opposed to company betas whenever available

Front 13

Real Options

Back 13

are capital budgeting options that allow managers to make decisions in the future that alter the value of capital budgeting investment decisions made today – sequential decisions;

Are similar to financial options, just with real assets instead of financial assets

Provide the right to make a decision, but NOT THE OBLIGATION

Front 14

Evaluation of real options

Back 14

DCF excluding the option – if it produces +NPV, the option is gravy

Project NPV = NPV (based on DCF alone) – Cost of Options + Value of Options

Decision trees - can capture the “essence” of sequential decision making problems

Option pricing models – less cost effective for simple options

Front 15

Common capital budgeting pitfalls

Back 15

a. Not incorporating economic responses into the investment analysis that later have an impact on profitability (new competition is often unanticipated appropriately)

b. Misusing capital budgeting templates

c. Pet projects – should receive the same type of scrutiny

d. Basing investment decisions on EPS, net income, or return on equity – often an issue when investors are too short-sighted or in need of managing earnings for personal gains

e. Using IRR to make investment decisions – use NPV instead – this bias often results in choosing shorter-term, smaller projects with high IRR, at the expense of larger, longer-term, high NPV

f. Bad accounting for cash flow

g. Overhead costs – forgetting to include overhead costs for implementation and future support

h. Not using the appropriate risk-adjusted discount rate – use the projects required rate of return, not the cost of debt (or the cost of equity) for the firm

i. Overspending and under-spending the capital budget – fear of losing it, if you don’t use it

j. Failure to consider investment alternatives

k. Handling sunk costs and opportunity costs incorrectly

Front 16

Claims valuation models

Back 16

valuing the liabilities (debt payments) and the equity (dividend distributions), and the claims against the assets, where the value of the claims should meet the value of the assets

Similar to the Free Cash Flow to Equity valuation approach

Front 17

The value of equity ='s

Back 17

the PV of cash distributions to equity (i.e. dividends) discounted at the cost of equity

Front 18

Capital structure

Back 18

the mix of debt and equity used to finance the business – looking to use an appropriate amount of leverage that maximizes the value of the company by minimizing the WACC

WACC = (D/V)rd(1 – T) + (E/V)re

Front 19

Modigliani-Miller: Proposition I without taxes

Back 19

Capital structure is irrelevant, assuming risk-free borrowing and lending, and investment and financing decisions independent of each other

In this environment, regardless of what the company’s capital structure is, an investor can borrow money to finance his /her ownership of the company to reflect a preferred debt financing

The value of a company is determined solely by its cash flows, not by the relative reliance on debt and equity capital

The increase in equity returns is exactly offset by increase in the risk and the associated increase in the required rate of return on equity

Value of the company levered = value of the company unlevered

Front 20

Modigliani-Miller: Proposition II without taxes

Back 20

The cost of equity is a linear function of the company’s d/e ratio

leverage raises the cost of equity– in order to maintain a constant WACC; as the company increases its use of debt financing, the cost of equity rises

WACC excluding taxes = (D / V)rd +(E/V)re

Asset beta – represents the amount of the assets’ risk that is non-diversifiable

According to M&M, the company’s cost of capital does not depend on its capital structure but rather is determined by the business risk of the company

Front 21

Modigliani-Miller: Proposition I with taxes

Back 21

M&M prove that due to the tax shield, the value of a company with debt is greater than that of the same company without debt, for the same level of operating income

Requires that the WACC for a company with debt is lower than a company with all equity

Proposition I with taxes = VL = VU + tD

Front 22

Modigliani-Miller: Proposition II with taxes

Back 22

M&M prove that due to the tax shield, the value of a company with debt is greater than that of the same company without debt, for the same level of operating income

Requires that the WACC for a company with debt is lower than a company with all equity

re = ro + (ro – rd)(1 - t)(D/E)

Front 23

Impact of financial distress

Back 23

adds costs, both explicit and implicit – may lose customers, creditors, suppliers, and valuable employees to more secure competitors – may go into bankruptcy

Front 24

Agency costs

Back 24

costs associated with the fact that all public companies and the larger private companies are managed by non-owners; costs that arise when an agent makes decisions for a principal – caused by a conflict of interests between managers, shareholders, and bondholders

The better a company is governed, the less agency costs

Monitoring costs (owners monitoring management), bonding costs (management assuring owners that they are working in the owners’ best interest); residual loss (costs incurred even when there is sufficient monitoring and bonding)

Free cash flow hypothesis – the more financially leveraged a company is, the less freedom management has to either take on more debt or unwisely spend cash

Front 25

Asymmetric information

Back 25

an unequal distribution of information, when managers have more information about the company than outsiders such as owners and creditors

Front 26

Pecking order theory

Back 26

suggests that managers choose methods of financing according to a hierarchy that gives first preference to methods with the least potential information content (internally generated funds) and lowest preference to the form with the greatest potential information content (public equity offering)

Front 27

Optimal capital structure

Back 27

the point at which further increasing value-enhancing effects (i.e. leverage) becomes value-reducing (i.e. financial distress costs) – considering these costs and the tax shield, there is an optimal capital structure where the value of the company is maximized

VL = VU + tD – PV(costs of financial distress)

Front 28

Static trade-off theory of capital structure

Back 28

when debt constitutes less than 100% of the company’s capital structure – where you have to balance the expected costs from financial distress against the tax benefits of debt service payments

Front 29

Target capital structure

Back 29

represents the most appropriate capital structure for the company based on the company’s risk appetite and/or stability of the business environment

Because short-term opportunities may arise, a company’s capital structure may fluctuate from time to time around the target

Front 30

The role of debt ratings in capital structure policy

Back 30

Debt ratings provide an independent evaluation of the company’s creditworthiness, the stability of the industry to which the company belongs, and an analysis of legal, institutional, and macroeconomic environment in which the company operates

As leverage rises, rating agencies tend to lower the ratings of the company’s debt to reflect higher credit risk from increasing leverage – a lower rating signals higher risk to both equity and debt capital providers, who would then demand higher returns

AAA is the highest rating to BBB (all investment grade – typically a 100bps spread between the best and the bottom of investment grade), and BB to DDD are speculative grade (big yield difference between spec and investment grade)

Moody’s, Standard & Poor’s and Fitch all operate separately from one another

Front 31

Factors to consider when evaluating the impact of capital structure policy on valuation

Back 31

The company’s capital structure over time, the capital structure of competitors that have similar business risk, and company-specific factors (quality of corporate governance)

Determine your own optimal capital structure for the company based on its ability to service debt

Front 32

International differences with regard to financial leverage

Back 32

Countries differ in their preference for leverage, short vs. long-term debt issuances, and their access to capital

France, Italy, and Japan tend to be more highly levered than the US and UK

NA tend to use longer-term debt than Japan

Developed markets tend to use longer-term debt than emerging markets

Front 33

Country-specific factors that may impact their appetite for leverage

Back 33

Institutional and legal environment – taxation, accounting standards, even the level of corruption would impact a company’s optimal capital structure

Financial markets and banking sector – the size and activity of the financial markets within a given country – crucial for access to capital

Macroeconomic environment – general economic and business environment, addresses the influence of economic growth and inflation on the capital structure

Front 34

Theories of dividend policy

Back 34

Dividend policy does not matter – only investments in working and financial capital impact shareholder’s wealth

Under M&M assumptions there is no meaningful distinction between dividends and share repurchases – relates closely to the homemade dividend, suggesting that if shareholders wanted or needed income, they could construct their own dividend policy by selling sufficient shares to create their desired cash flow stream

Dividend policy does matter – do investors value a unit of dividend more highly than equal amounts of uncertain capital gains?

Bird in the hand argument: less risky to have the dividend in hand, than just the prospect of future cash flows

Tax argument – capital gains vs. dividend tax rates vs. share repurchase

Front 35

Signals insinuated from changes or lack thereof dividend policy

Back 35

Increasing a dividend could suggest a sound future – but may signal limited growth opportunities (i.e. no better use for that cash?)

Decreasing a dividend could suggest a bleak outlook – needing the cash to pay creditors, or could signal the need for cash to invest in growth opportunities (typically the former)

No dividend could suggest heavy growth phase, or an unfavorable tax climate

Front 36

Clientele effects

Back 36

the existence of groups of investors (clienteles) attracted by (and drawn to invest in) companies with specific dividend policies – retired investors looking for a steady income, tax considerations (dividends vs. capital gains), institutional investors

Front 37

Alleviating agency issues with dividends

Back 37

Agency issues may be alleviated by a dividend payment – some sense of security by investors that the agents (management) are not squandering capital

But paying a dividend when a company is highly leveraged, could create a conflict of interest when wealth is essentially shifting from bondholders to shareholders

Front 38

Factors that affect dividend policy

Back 38

Investment opportunities

The expected volatility of future earnings

Financial flexibility

Tax consideration

Flotation costs

Contractual and legal restrictions

Front 39

Double-taxation

Back 39

when corporate earnings are taxed at the corporate level and then taxed again at the shareholder level if they are distributed to taxable shareholders as dividends

Front 40

Split rate

Back 40

corporate earnings that are distributed as dividends are taxed at a lower rate at the corporate level than earnings that are retained. And for the individual investor, dividends are taxed as ordinary income (still double taxation, but to a lesser degree at the corporate level)

Front 41

Tax imputation dividend tax regimes

Back 41

ensures that corporate profits distributed as dividends are taxed just one, at the shareholder’s tax rate; taxed first at the corporate level, but then shareholders receive a credit (franking credit) for the taxes that the corporation paid on those distributed earnings

If the shareholder’s marginal tax rate is higher than the company’s, the shareholder pays the difference between the two rates, and vice versa

Front 42

Stable dividend

Back 42

regular dividends are paid that generally do not reflect short-term volatility in earnings; most common form, because it reduces the risk of dividend cuts

Expected dividend = last dividend + (expected increase in earnings x target payout ratio X adjustment factor)

Adjustment factor = 1/# of years for adjustment

Front 43

Target payout dividend

Back 43

paying out a percentage of net income; DPS/EPS = % payout ratio

Front 44

Residual dividend payout

Back 44

Paying out as dividends any internally generated funds remaining after such funds are used to finance positive NPV projects; rarely used in practice

Dividend = earnings – (capital budget x equity percent in capital structure) or zero

Front 45

Global trends in corporate dividend/shareholder return policies

Back 45

the number of companies paying dividends has been in a long-term decline in most developed markets: US, CAD, EU, UK, and Japan

meanwhile, the number of companies repurchasing shares is on an upward trend

Front 46

Share repurchasing advantages compared to cash dividends

Back 46

Potential tax advantages

Share price support – signals the company’s shares are a good investment

Added managerial flexibility (you don’t have to be consistent, like you do with dividends)

Offsetting dilution from employee stock options

Increasing financial leverage

Increasing EPS – often problematic, bc share repurchase increases leverage and bc lower share count does not affect shareholder wealth as FCF is unchanged

Cash dividends and repurchasing shares are considered to have an equal effect on shareholder wealth, all other things being equal

Front 47

Signals that a company may not be able to sustain its dividend

Back 47

The level of the dividend ratio

Whether the company has to borrow to pay the dividend

Company’s past dividend record:

i. although past financial data does not always predict dividend safety
ii. for the vast majority of common stocks, the dividend record and prospects have always been the most important factor controlling investment quality and value

Front 48

Corporate governance

Back 48

is the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form

Front 49

Two main objectives of corporate governance

Back 49

To eliminate or mitigate conflicts of interest, particularly those between managers and shareholders

To ensure that the assets of the company are used efficiently and productively and in the best interests of its investors and other stakeholders

Front 50

Attributes of an effective corporate governance system

Back 50

Delineation of the rights of shareholders and other core stakeholders

Clearly defined manager and director governance responsibilities to stakeholders

Indentifiable and measurable accountabilities for the performance of the responsibilities

Fairness and equitable treatment in all dealings between managers, directors, and shareholders

Complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position

Front 51

Sole partnership

Back 51

sole owner, few legal requirements, entity is easily formed, no legal distinction between the owner and the business; unlimited liability by the owner; very limited ability to raise capital; non-transferable (except by sale) ownership; essential that the owner is an expert in his/her business

Front 52

Partnership

Back 52

multiple owners, few legal requirements, entity is easily formed, no legal distinction between the owner and the business; unlimited but at least shared liability among owners/partners; limited ability to raise capital; non-transferable ownership; essential that the owners are experts in the business

Front 53

Corporation

Back 53

unlimited ownership; numerous legal and regulatory requirements; legal separation between owners and business; limited liability to owners; nearly unlimited access to capital; easily transferable ownership; unnecessary to be an expert in the business

Front 54

Conflicts that arise in agency relationships

Back 54

Agency problem: when manager and shareholder/director interests are not aligned

Managers and shareholders: whether management will act for the good and value creation for shareholders, or in their own best interests

Directors and shareholders: directors should serve as agents of the shareholders, to ensure that interests are being well served – directors review M&A, review/audit financials, set compensation + bonus, and discipline poor performing managers

The main conflict that can arise, is when directors come to identify with the managers’ interests rather than the shareholders – occurs when the board is not independent, or when there are personal relationships between managers and the board, or inter-linkage between boards; overpayment of directors is also a frequent problem

Front 55

Responsibilities of the board of directors

Back 55

Establish corporate values and governance structure for the company to ensure that the business is conducted in an ethical, competent, fair, and professional manner

Ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion

Establish long-term strategic objectives for the company with a foal of ensuring that the best interests of shareholders come first and that the company’s obligations to others are met in a timely and complete manner

Establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company’s operations

Hire the CEO, determine the compensation package, and periodically evaluate the officer’s performance

Ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decisions that are its responsibility, and to be able to adequately monitor and oversee the company’s management

Meet frequently enough to adequately perform its duties, and meet in extraordinary session as required by events

Acquire adequate training so that members are able to adequately perform their duties

Front 56

Desired director qualifications & core competencies

Back 56

Independence – at least a majority (3/4 recommended)

Skill & Experience – expertise in the industry, or within business matters; experience in strategic planning and risk management

Indication of ethical soundness

Other board experience with companies regarded as having sound governance practices

Resources – authority to hire external auditors and other outside consultants without management’s intervention or approval

Accurate information about the company’s financial and operating position

Dedication and commitment to serving the board and investors’ interests – serving on multiple boards may be a conflict, want solid attendance records, and limited other commitments)

Front 57

Lack of independence "qualities/examples" of a board

Back 57

former employment at the company

business and/or personal relationships

interlocking directorships

ongoing banking or other creditor relationship

Front 58

Effective corporate governance practices

Back 58

Independence

Not best practice when the CEO is also Chairman of the board

Annual or staggered elections (staggered is often preferred by companies, less of a disruption, also helps with continuity of knowledge, but best practice generally supports annual – so as not to be stuck with a “dud” for three years)

Annual board self-assessment – as a whole, as individuals, a review of activities, an evaluation of qualities to achieve in the future, and a final report within the proxy

Separate sessions of independent directors at least annually, preferably quarterly

Establishment of an independent audit committee with sufficient expertise in accounting + legal matters, oversees the internal audit function with the internal audit staff reporting directly to the committee , have sufficient resources, the cooperation of management, the authority to hire auditors, meet with auditors independently of management or other insiders, have full authority to review the audit and financial statements – determining the quality and transparency of financial reporting choices

Nominating committee – establish criteria for evaluating director candidates or senior management positions, identify candidates, review qualifications of the nominees, document reasons for the selection of candidates recommended

Compensation committee – determining salary generally set by contractual commitments between company and the executive/director; prerequisites, additional comp with benefits; bonus awards – normally aligned with company performance and long-term goals and objectives; stock options, awards, restricted stock (etc.)

Repricing options when they are out of the money (above the current stock price) – must expense the difference in the IS

Front 59

Elements of a company's statement of corporate governance policies that an analyst should analyze

Back 59

Quality, clarity, timeliness, and completeness of financial information in valuing securities and assessing risk

Code of ethics

Statements of oversight, monitoring, and review responsibilities of directors, including internal control, risk management, audit and accounting and disclosure policy, compliance assessment, nominations, compensation awards, and other responsibilities

Statements of management’s responsibilities to provide complete and timely information to the board members prior to board meetings, and to provide directors with free and unfettered access to control and compliance functions within the company

Reports of directors’ examinations, evaluations, and findings in their oversight and review function

Board and committee performance self-assessments

Management performance assessments

Training provided to directors prior to joining the board and periodically thereafter

Front 60

Accounting risk

Back 60

financial statements are incomplete, misleading, or materially misstated

will have a material impact on valuation

Front 61

Asset risk

Back 61

assets will be misappropriated by mangers or directors in the form of excessive compensation or other perquisites

will have a material impact on valuation

Front 62

Liability risk

Back 62

that management will enter into excessive obligations, committed to on behalf of shareholders, that effectively destroy the value of SE; frequently take the form of off-balance sheet obligations

will have a material impact on valuation

Front 63

Strategic policy risk

Back 63

that managers may enter into transactions, such as M&A, or incur other business risks that may not be in the best long-term interest of shareholders, but which may result in large payoffs for management or directors

will have a material impact on valuation

Front 64

Acquisition

Back 64

is the purchase of some portion of one company by another

Front 65

Merger

Back 65

the absorption of one company by another

Front 66

Statutory merger

Back 66

one of the companies ceases to exist as an identifiable entity and all its assets and liabilities become part of the purchasing company

Front 67

Subsidiary merger

Back 67

company being purchased becomes a subsidiary of the purchases (often occurs when the company being purchased has a strong brand or good image among consumers that the acquiring company wants to retain)

Front 68

Consolidation

Back 68

similar to statutory merger, but here, both companies terminate their previous legal existence and become part of a newly formed company (common when both companies are approximately the same size)

Front 69

Horizontal M&A

Back 69

when merging companies are in the same kind of business, usually as competitors; often in pursuit of economies of scale – savings achieved through the consolidation of operations and the elimination of duplicate resources

Front 70

Vertical M&A

Back 70

when the acquirer buys another company in the same production chain (i.e. a supplier or distributor) to gain greater control over the production process in terms of quality or procurement of resources, or the distribution of finished goods

Front 71

Backwardation integration

Back 71

if the acquirer purchases up the value chain, a supplier

Front 72

Forward integration

Back 72

if the acquirer purchases down the value chain, a distributor

Front 73

Conglomerate

Back 73

when an acquirer purchaser another company that is unrelated to its core business for company level diversification (GE example)

Front 74

Common motivations behind M&A

Back 74

Basic motivations include: search for economies of scale in a horizontal merger, or cost savings through integration in a vertical merger

Synergy – where the combined company should be worth more than the sum of its parts – often will either reduce costs or enhance revenues

Growth – external growth vs. organic growth, sometimes is safer than green-fielding

Increasing Market Power – gaining share with horizontal integration, or even creating a captive market with vertical integration

Acquiring unique capabilities and resources – for competitive purposes or to shore up lacking resources (acquiring strong R&D, sales team, intellectual capital, creative talent)

Diversification – often with conglomerates; not always in the best interest of shareholders

Managers’ personal incentives – often because compensation is based on size, so managers are incentivized to get bigger and acquire

Tax considerations – to lower the tax liability

Unlocking hidden value through reorganization, access to better management, or synergy – often done at less than break-up value (if you sold the company into its parts)

Cross-border motivations – to extend market reach and gain international expertise

Front 75

Bootstrapping

Back 75

when a company’s earnings increase as a consequence of the merger transaction itself (rather than b/c of resulting economic benefits of the combination)

Occurs when the shares of the acquirer trade at a higher P/E than those of the target, and the acquirer’s P/E does not decline following the merger

Calculation – determine the market value of equity for each portion (based on P/E*total earnings (total earnings = EPS*total shares outstanding)

Determine how many shares would need be issued to acquire the target company: target market value / stock price of acquirer = shares needed to issue

Calculate the “new” earnings (due to bootstrapping) by summing the total earnings of acquirer + target and divide by total shares outstanding (acquirer + shares needed to issue)

Accretion = new earnings – acquirer earnings (all due to the difference in P/E)

Front 76

Pioneering development M&A

Back 76

industry has substantial development costs and has low, but slowly increasing sales growth

Motives: younger, smaller companies acquired by larger companies that have the resources, but lack growth; or younger companies combining together for scale

Types: Conglomerate or Horizontal

Front 77

Rapid accelerating growth M&A

Back 77

industry has high profit margins caused by few market participants

Motives: explosive growth in sales requires large capital requirements to expand capacity

Types: Conglomerate or Horizontal

Front 78

Mature growth M&A

Back 78

industry has a drop in the entry of new competition, but growth remains

Motives: mergers for economies of scale, savings, and operational efficiencies

Types: horizontal and vertical

Front 79

Stabilization and market maturity M&A

Back 79

industry has increasing competition and capacity constraints

Motives: economies of scale in operations to improve competitive low cost positioning and or pricing (domestically and foreign)

Types: horizontal

Front 80

Deceleration of growth and decline M&A

Back 80

overcapacity and eroding profit margins

Motives: to ensure survival (horizontal), increase efficiency and profit margins (vertical), companies in related industries may merge to exploit a synergy, companies in this industry may acquire companies in young industries

Types: horizontal, vertical, conglomerate

Front 81

Stock purchase acquisition

Back 81

when the acquirer gives the target company’s shareholders some combination of cash and securities in exchange for the shares of the target company’s stock (must have at least 50% shareholder approval); no corporate-level taxes, target shareholders are taxed on capital gains, acquirer assumes the target’s liabilities

Front 82

Asset purchase acquisition

Back 82

the acquirer purchases the target company’s assets and payment is made directly to the target company (is quicker and normally does not require approval) – and enables the buyer to buy only the assets they want/need; target company pays taxes on any capital gains, no direct tax consequence for the target company’s shareholders, and acquirer often avoids acquiring liabilities

Front 83

Methods of M&A payment

Back 83

Cash offering – either from acquirer’s existing assets or a debt issuance

Mixed offering – combination of cash and stock

Securities offering – target shareholders receive shares of the acquirer’s common stock

Front 84

Exchange ratio for securities offerings

Back 84

determines the number of shares the stockholders in the target company receive in exchange for each of their shares in the target company – typically negotiated in advance for a range of stock prices

Front 85

Method of payment impact on the distribution of risk and reward between acquirer and targer

Back 85

often when management is confident in the value creation opportunity, they will do all cash offer to capture all of the upside

Front 86

Definitive merger agreement

Back 86

a contract written by both companies’ attorneys and is ultimately signed by each party to the transaction

Front 87

Friendly Merger attributes

Back 87

have a definitive merger agreement

proxy statement for instances when a shareholder vote is required

Front 88

Hostile takeover types

Back 88

bear hug

tender offer

proxy fight - trying to take control through a shareholder vote

Front 89

Bear hug

Back 89

submitting a merger proposal directly to the target company’s board, bypassing management/CEO

Front 90

Tender offer

Back 90

the acquirer invites target shareholders to submit their shares in return for the proposed payment (can be cash or stock transactions)

Front 91

Pre-offer defense mechanisms

Back 91

rights-based defenses: poison pills and poison puts, changes to the corporate charter (staggered boards and super majority provisions); shark repellents; incorporation in a state with restrictive takeover laws; staggered board of directors; restricted voting rights; supermajority voting provisions; fair price amendments; golden parachutes

Front 92

poison pills

Back 92

a pre-offer defense mechanism: a legal device that makes it prohibitively costly for an acquirer to take control of a target without the prior approval of the target’s board of directors

Front 93

flip-in pill

Back 93

when the common shareholder or the target company has the right to buy its shares at a discount

a pre-offer defense mechanism

Front 94

Dead-hand provision

Back 94

allows the board of the target to redeem or cancel the poison pill only by a vote of the continuing directors

a pre-offer defense mechanism

Front 95

Poison puts

Back 95

a pre-offer defense mechanism

give rights to the target company’s bondholders – allow the bondholders to put the bonds to the company and force the acquirer to refinance the target’s debt immediately

Front 96

iIncorporation in a state with restrictive takeover laws (US)

Back 96

a pre-offer defense mechanism

– enables flexibility in dealing with unwanted suitors – target friendly states: OH, PA

Front 97

Staggered board of directors

Back 97

a pre-offer defense mechanism

only a portion of the board comes up for election each year, requiring an acquirer to wait at least two years

Front 98

Restricted voting rights

Back 98

a pre-offer defense mechanism

in-place triggers, restricting someone from acquiring large amounts of shares over a certain amount (typically 15-20%)

Front 99

Supermajority voting provisions

Back 99

a pre-offer defense mechanism

requiring a high % of shareholder approval above the typical 51% majority (often as high as 80%)

Front 100

Fair price amendments

Back 100

a pre-offer defense mechanism

disallow mergers below some predetermined threshold

Front 101

Golden parachutes

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a pre-offer defense mechanism

compensation agreements between the target company and its senior managers, providing managers with lucrative pay days if they leave the target company after a change in control (more for management “safety” less related to deal deterrent)

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POST-OFFER defense mechanisms

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not always upheld in court, but typically used in conjunction with a pre-offer defense:

“Just say no” defense
Litigation
Greenmail
Share repurchase - sometimes they go so far as to take private, a leveraged buyout
Leveraged recapitalization
“Crown jewel” defense
“Pac-man” defense
White knight defense
White squire defense

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Litigation - defense mechanism

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a post-offer defense mechanism

file a lawsuit against the acquiring company based on alleged violations or securities or antitrust laws (more to delay…)

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Greenmail

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a post-offer defense mechanism

allows the target to repurchase its own shares back from the acquiring company, usually at a premium to the market price

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Share repurchase - M&A defense mechanism

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a post-offer defense mechanism

acquiring shares from other shareholders, not just the acquiring company - sometimes they go so far as to take private, a leveraged buyout

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Leveraged recapitalization

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a post-offer defense mechanism

the assumption of a large amount of debt that is then used to finance share repurchases, but some shares remain in the hands of public shareholders

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“Crown jewel” defense

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a post-offer defense mechanism

the target sells off a subsidiary or asset to a third party (often the main motivation behind the takeover offer)

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“Pac-man” defense

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a post-offer defense mechanism

making a counteroffer to the acquire the hostile bidder (rare because the acquirer is often much bigger than the acquirer)

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White knight defense

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a post-offer defense mechanism

target company seeks a third party to purchase the company in lieu of the hostile bidder (coming to the aid of the target company)

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White squire defense

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a post-offer defense mechanism

target seeks a friendly party to buy a substantial minority stake in the target – enough to block the hostile takeover without selling the entire company

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Antitrust

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to ensure that markets remain competitive

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SEC "purpose"

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to maintain both fairness in merger activities and confidence in the financial markets

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Herfindal-Hirschman index

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is a measure of market power/concentration = the sum of market shares (in % form) squared

If HHI is less than 1,000, the market is not considered to be concentrated and a challenge is unlikely unless other anti-competitive issues arise

If HHI is between 1,000 and 1,800, a market is considered moderately concentrated

If HHI is 1,800 or more is a concentrated market and would require a comparison of post-merger and pre-merger HHI

If this comparison results in an increase of 100 points in a moderating concentrated or 50 points in a highly concentrated market, it is likely to evoke antitrust concerns

Smaller increases would likely not cause a problem

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Discounted cash flow method - advantages and disadvantages

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discounts the company’s expected future free cash flows to the present in order to derive an estimate for the value of the company

Advantages: changes in a company’s cash flows can be readily modeled; estimate of intrinsic value based on forecast fundamentals is provided by the model; changes in assumptions and estimates can be incorporated by customizing and modifying the model

Disadvantages: difficult to apply when FCFs do not align with profitability within the first stage (in fact FCFs may be negative); estimating FCFs and earnings is not an exact science; discount rate estimates can change over time (based on the market);

terminal value estimates are often subject to acquisition values – and can have varying degrees of estimation error – plus have a dramatic impact on DCF final output (WACC estimate too)

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Comparable company method - advantages and disadvantages

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defines a set of other companies that are similar to the target company under review – may include other companies within the primary industry, as well as similar industries

Advantages: assumes “like” assets should be valued on a similar basis; most of the required data are readily available; estimates are derived directly from the market (not from assumptions or estimates)

Disadvantages: sensitive to market mispricing, this approach determines fair market price and then requires an additional assumption for a takeout premium; difficult for the analyst to incorporate and specific plans of the target (changing capital structure, etc.); data for past premiums may be stale

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Comparable Transaction method - advantages and disadvantages

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similar to comparable company, but the analyst uses details from recent takeover transactions

Advantages: not necessary to separately estimate a takeover premium; estimates come directly from actual market transactions, and this reduces litigation risk because there is price basis in the market

Disadvantages: assumes M&A market has properly valued assets; there may be no comparable transactions in the market; may be inaccurate, bc hard to determine the plans for the target (changing capital structure, etc)

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Premiums in acquisitions

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Acquirers must typically pay a premium to induce the owners of the target company to relinquish control – premium is the portion of the compensation received by the target company’s shareholders that is in excess of the pre-merger market value of their shares

Target Shareholders’ Gain = Premium = Price Paid by acquirer – pre-merger value of target

Acquirers will pay in excess of the target company’s value in anticipation of reaping its own gains – typically cost savings and/or revenue enhancements

Acquirer’s gain = synergies – Premium = S – (Pt – Vt)

Post merger value of the combined company = pre-merger value of the acquirer + value of the target + synergies – cash paid to target shareholders

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Cash offer

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take the $ per share offered for the target company and compute the premium, and then subtract that premium from expected synergies to determine the stock appreciation to the acquirer

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Stock offer

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use the announced ratio to find the target’s premium and post-merger value

take the offered ratio x the share price of the acquirer

determine the needed shares to issue: ratio x the target’s shares outstanding – or the dilutive impact to acquirer shareholders

Find the post-merger market value = pre-merger value of the acquirer + value of the target + synergies – cash paid (should be zero), and then divide by new shares outstanding (inclusive of the issuance) for the new “share price of the acquirer”

Target’s premium is then the new share price of the acquirer x the # of shares issued, less the pre-merger value of the company

Acquirer’s $ accretion is then the synergies less the target’s premium

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Mixed offer

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shares and cash – some dilution but not as much to the acquirer’s shareholders

Determine the cash portion first: value of the acquirer + value of the target + synergies - $ per share offered (costs)

Find the share count dilution by taking the ratio x the target’s pre-merger shares outstanding + the acquirer’s pre-merger shares outstanding, then divide the value found in step one by the new acquirer’s share count = the $ per share of the acquirer + accretion

Target’s premium is found by adding the cash per share value + the acquirer’s new share price X the number of shares issued less the pre-merger value of the target company

Acquirer’s gain is then synergies less target premium

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Empirical evidence related to the distribution of benefits in a merger

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The more confident managers are in estimated synergies, the more acquiring managers will prefer to pay in cash, and the more target companies will prefer to receive stock; BUT the more of the price paid in stock, the greater the risks and benefits of realizing synergies is passed on to the target shareholders

Relative values of the companies is also a factor to consider, the more confident managers are in the estimate of the target company’s value, the more they would prefer to pay in cash and the more the target would prefer stock

Target shareholders reap 30% premiums over the stock’s pre-announcement market price, and the acquirer’s stock price falls, on average between 1-3%

But on average, both the acquirer and target tend to see higher stock returns surrounding cash acquisition offers than around stock offers

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Equity Carve Out

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the creation of a new legal entity and sales of equity in it to outsiders

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Spin-Off

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shareholders of the parent company receive a proportional number of shares in a new, separate entity vs. the sale of a division, which is typically a cash inflow to the parent company

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Split-Off

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similar to a spin-off, but where some of the parent company’s shareholders are given shares in a newly created entity in exchange for their shares of the parent company

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Liquidation

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breaking up a company, division, or subsidiary and selling off its assets piecemeal (typically associated with bankruptcy)