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CFA2: Corporate Finance

Capital Budgeting

  • Initial outlay = price of building + price of equipment + NWCInv
  • Operating cash flows: CF = (S – C)(1 – T) + DT
  • Terminal year after-tax non-operating cash flows
  • Decision based on NPV and IRR

Effects of inflation

  • Analyzing nominal or real cash flows: Nominal cash flows should be discounted at a nominal discount rate, while real cash flows should be discounted at a real discount rate.
  • Changes in inflation affect project profitability: If inflation is higher (lower) than expected, future project cash flows are worth less (more), and the value of the project will be lower (higher) than expected.
  • Inflation reduces the tax savings from depreciation: If inflation is higher than expected, the firm’s real taxes are effectively increased because the depreciation tax shelter is less valuable.
  • Inflation decreases the value of payments to bondholders: Bondholders receive fixed payments that are effectively worth less as inflation increases.
  • Inflation may affect revenues and costs differently: If prices of goods change at a different rate than the prices for inputs used to create those goods, the firm’s after-tax cash flows may be better or worse than expected.

When comparing projects with unequal periods

  • The least common multiple of lives approach extends the lives of the projects so that the lives divide equally into the chosen time horizon. It is assumed that the projects are repeated over the time horizon, and the NPV over this horizon is used as the decision criterion.
  • The equivalent annual annuity of each project is the annuity payment each project year that has a present value (discounted at the WACC) equal to the NPV of the project.

Capital rationing the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth. A firm with less capital than profitable (i.e., positive NPV) projects should choose the combination of projects they can afford to fund that has the greatest total NPV.

Stand-alone risk assessment

  • Sensitivity analysis is the altering or changing of an input (independent) variable to see how sensitive the dependent variable is to the input variable.
  • Scenario analysis is a risk analysis technique that considers both the sensitivity of the dependent variable (for example NPV) to changes in a key independent input variable (for example, sales) and the likely range of the variable’s values (the variable's probability distribution). In scenario analysis, we study the different possible scenarios, worst case, best case, and base case.
  • Monte Carlo simulation uses simulation techniques to tie together sensitivities and probability distributions of input variables like sales, variable cost per unit, etc. Random values of input variables are generated, and then the NPV’s are computed. This procedure is repeated for as many as 10,000 times and from this set of 10,000 NPV values, the mean and standard deviation of a project’s NPV is computed.

Security Market Line

Rproject = RF + bproject [E(RMKT – RF)]

Real options allow managers to make future decisions that change the value of capital budgeting decisions made today.

  • Timing options allow a company to delay making an investment.
  • Abandonment options allow management to abandon a project if the PV of the incremental CFs from exiting a project exceeds the PV value of the incremental CFs from continuing a project.
  • Expansion options allow a company to make additional investments in a project if doing so creates value.
  • Flexibility options give managers choices regarding the operational aspects of a project. The two main forms are price-setting and production flexibility options.
  • Fundamental options are projects that are options themselves because the payoffs depend on the price of an underlying asset.

Evaluation using the NPV of the project without the option, or calculate the project NPV without the option and add the estimated value of the real option, or use decision trees, or use option pricing models.

Common mistakes in the capital budgeting process include:

  1. Failing to incorporate economic responses into the analysis.
  2. Misusing standardized project evaluation templates.
  3. Having overly optimistic assumptions for pet projects of senior management.
  4. Basing long-term investment decisions on short-term EPS or ROE considerations.
  5. Using the IRR criterion for project decisions.
  6. Poor cash flow estimation.
  7. Misestimation of overhead costs.
  8. Using a discount rate that does not accurately reflect the project’s risk.
  9. Politics involved with spending the entire capital budget.
  10. Failure to generate alternative investment ideas.
  11. Improper handling of sunk and opportunity costs.

A project’s economic income is equal to the after-tax cash flow plus the change in the investment’s market value. Interest is ignored for cash flow calculations and is instead included as a component of the discount rate.

A project’s accounting income is the reported net income on a company’s financial statements that results from an investment in a project. Accounting income will differ from economic income because:

  • Accounting depreciation is based on the original cost (not market value) of the investment.
  • Financing costs are considered as a separate line item and subtracted out to arrive at net income. In the basic capital budgeting model, financing costs are reflected in the WACC.

Alternative valuation models

  • Economic profit is calculated as NOPAT – $WACC. Economic profit reflects the income earned by all capital holders and is therefore discounted at the WACC to determine the market value added (MVA) or NPV of the investment.
  • Residual income is focused on returns to equity holders and is calculated as net income – equity charge. Residual income reflects the income to equity holders only and is discounted at the required return on equity to determine NPV.
  • Claims valuation separates cash flows based on the claims that equityholders and debtholders have on the asset. Cash flows to debt holders are discounted at the cost of debt and cash flows to equity holders are discounted at the cost of equity. The present value of each set of cash flows is added together to determine the NPV of the project.

Capital Structure

  • Leverage refers to the amount of fixed costs a firm has. Greater leverage leads to greater variability of the firm’s after-tax operating earnings and net income.
  • Business risk: risk associated with a firm’s operating income and is the result of uncertainty about a firm’s revenues and the expenditures necessary to produce those revenues.
    • Sales risk: uncertainty about the firm’s sales.
    • Operating risk: additional uncertainty about operating earnings caused by fixed operating costs. The greater the proportion of fixed costs to variable costs, the greater a firm’s operating risk.
  • Financial risk: additional risk that the firm’s common stockholders must bear when a firm uses debt financing.

Operating leverage: a greater proportion of fixed costs compared to variable costs in a firm’s capital structure. A firm with high operating leverage will have EBIT that is highly sensitive to changes in revenues and, as a result, has high operating risk. A given percentage change in sales leads to a greater percentage change in EBIT. However, higher operating risk also means a greater opportunity for reward as the firm can earn larger profits as the number of units sold increases.

Degree operatingleverage.gif

Financial leverage use of fixed cost financing. It magnifies the earnings variability per share compared to the variability of operating earnings (EBIT). Firms with a high degree of financial leverage will experience large changes in EPS for a given change in EBIT.

Degree financialleverage.gif

Total leverage sensitivity of EPS to changes in sales. If a firm has high total leverage, a small change in sales will produce a large change in EPS.

Degree totalleverage.gif

Breakeven quantity of sales for operating profit

QBE = F / (P – V)
  • Financial leverage change in earnings per share (net income) for a given change in EBIT (operating income). Use of financial leverage significantly increases the risk and potential reward to common stockholders.
  • The use of debt in a company’s capital structure reduces net income due to the added interest expense, but can increase equity owners’ ROE.
  • Creditor risk debt holders In exchange for loaning money to a business, creditors receive interest and principal payments that must be made regardless of the business’s profitability. If the business defaults on its debt payments, it can lead to bankruptcy. If bankruptcy occurs, creditors have a priority claim on the assets of the business, which gives them a higher level of safety compared to owners. Creditors have less risk than owners, but they also have less potential for return. Even if the business is extremely profitable, debt holders will not receive more than the promised interest and principal payments.
  • Owner risk equity holders of a business have a claim to what is left over after all expenses. In the event of bankruptcy, all creditors must be paid in full before equity holders are paid. In many cases, the value of the equity stake is reduced to zero as a result of bankruptcy. In exchange for this risk, equity holders make the business decisions, including the hiring or firing of managers and dividend payouts.
  • Objective of the capital structure decision: to determine the optimal proportion of debt and equity financing that will minimize the firm’s weighted average cost of capital (WACC). This is also the capital structure that will maximize the value of the firm.

Modigliani and Miller(MM) propositions based on assumption of a perfect market in which there are no taxes, no cost of bankruptcy, and homogeneous expectations

  • MM Proposition I (No Taxes): The Capital Structure Irrelevance Proposition
value of a firm is unaffected by its capital structure
  • MM Proposition I (With Taxes):
since debt interest payments are tax deductible, value is maximized at 100% Debt
  • MM Proposition II (No Taxes): Cost of Equity and Leverage Proposition
As companies increase their use of debt, the risk to equityholders increases, which in turn increases the cost of equity. Therefore, the cost benefits to using a larger proportion of debt as a cheaper source of financing are offset by the rise in the cost of equity, resulting in no change in the firm’s WACC.
  • MM Proposition II (With Taxes): WACC Is Minimized at 100% Debt
  • Costs of financial distress: increased costs companies face when earnings decline and the firm has trouble paying its fixed costs
  • Agency costs of equity: costs associated with the conflicts of interest between managers and owners. Shareholders will take steps to minimize these costs and greater amounts of financial leverage tend to reduce agency costs.
  • Costs of asymmetric information: costs for lack of transparency on financial statements for which managers have more information about a company’s prospects than owners or creditors
  • Pecking order theory: managers prefer to make financing choices that are least likely to send signals to investors

Static trade-off theory seeks an optimal capital structure with an optimal proportion of debt, to balance the costs of financial distress with the tax shield benefits from using debt

  • optimal proportion of debt is reached when the marginal benefit provided by the tax shield of taking on additional debt is exceeded by the marginal costs of financial distress from the additional debt

Target capital structure a model for making decisions on raising additional capital.

  • towards optimal capital structure
  • actual capital structure tends to fluctuate due to
    1. management decision to exploit opportunities in a specific financing source.
    2. market value fluctuations

Debt ratings: creditworthiness of a company’s debt, determines levels of default risk, therefore cost of capital

Evaluation factors:

  1. Changes in the company’s capital structure over time
  2. Capital structure of competitors with similar business risk
  3. Agency costs factors, such as quality of corporate governance
  • Scenario analysis is a useful tool to determine whether management’s current capital structure policy is maximizing the value of the firm.

Impact of Country-Specific Factors on Capital Structure
Country Specific Factor Use of Total Debt Maturity of Debt
Institutional and Legal Factors
Strong legal system Lower Longer
Less information asymmetry Lower Longer
Favorable tax rates on dividends Lower N/A
Financial Market Factors
More liquid stock and bond markets N/A Longer
Greater reliance on banking system Higher N/A
Greater institutional investor presence Lower Longer
Macroeconomic Factors
Higher inflation Lower Shorter
Higher GDP growth N/A Longer

Dividend Policy

Cash dividends: net effect to transfer cash to shareholders

  • Regular dividends - quarterly or annually
  • Special dividends - on times of success
  • Liquidating dividends - on bankruptcy
  • Stock dividends: dividends paid out in new shares of stock rather than cash.
  • Stock splits: divide existing share into multiple shares
  • Reverse stock splits: the opposite of stock splits

Share repurchase: transaction in which a company buys back shares of its own common stock; an alternative to a cash dividend

  • share repurchase using borrowed funds: If the company’s E/P is greater than (less than) the after-tax cost of borrowing(kd), EPS will increase (decrease)
  • impact on Book Value Per Share = book value after repurchase / #adjusted shares
  • Repurchase methods:
    1. Buy in the open market: at the prevailing market price, flexibility to choose the timing of the transaction
    2. Buy a fixed number of shares at a fixed price: a tender offer to repurchase a specific number of shares at a price that is usually at a premium
    3. Repurchase by direct negotiation: direct negotiation with a large shareholder; If the firm pays more than market value for the shares, the result is an increase in wealth for the seller and an equal decrease in wealth for remaining firm shareholders

Payment procedure

  • Declaration date: board of directors approves payment
  • Ex-dividend(Record-D2): the cut-off date for receiving the dividend
  • Holder-of-record date: shareholders of record are designated
  • Date of payment:dividend transferred to shareholder accounts

Dividend payout policy factors

  1. Signaling effect: stockholders perceive changes in dividend policy as conveying important information about the firm
  2. Taxation of dividends: Investors are concerned about after-tax returns
  3. Clientele effect: varying preferences for dividends of different groups of investors
  4. Restrictions on dividend payments: restriction either by legal requirements or implicit cash needs of the business
  5. Flotation costs on new issues vs. cost of retained earnings: not favorable to fund its dividend payments by issuing new shares of stock
  6. Shareholder preference for current income vs. capital gains: investors may not prefer a higher dividend even if the tax rate on dividends is more favorable because of tax timing, step-up valuation, tax-exempt institutions

Effective tax rate

  • Double taxation system: tcorp + (1 – tcorp)(tindividual)
  • Split-rate system: reduced corporate tax rate on dividend portion
  • Imputation system: the corporation pays dividend according to each shareholder's tax bracket

  • Unexpected dividend increase -> company’s future business prospects are strong and that managers will share the success with shareholders
  • Unexpected dividend decreases or omissions -> negative signals that the business is in trouble and that management does not think the current dividend payment can be maintained
  • in Japan and other Asian countries, investors are less likely to assume that even a large change in dividend policy signals anything about a company’s future

  • Residual dividend approach dividends are based on earnings-retained funds to finance the equity portion of its capital budget
    • Advantages: easy for the company to use, maximizes allocation of earnings to investment.
    • Disadvantages: dividend fluctuates with investment opportunities and earnings, uncertainty causes higher expected return and lower valuation.
  • Longer-term residual dividend: Company forecasts its capital budget over a longer time frame and attempts to provide a more steady dividend payout.
  • Dividend stability: Company tries to align its dividend growth rate with the company’s long-term growth rate to provide a steadily increasing dividend.
  • Target payout ratio Company defines a proportion of earnings that it plans to pay out to shareholders over the long term.
Expected dividend.gif
adjustment factor = 1 / number of years over which the adjustment in dividends will take place

Common rationales for share repurchases:

  1. It prevents EPS dilution that comes from the exercise of employee stock options.
  2. A company could declare a regular cash dividend and periodically repurchase shares as a supplement to the dividend. #Unlike dividends, share repurchases are not a long-term commitment. Since paying a cash dividend and repurchasing shares are economically equivalent, a company could declare a small stable dividend, and then repurchase shares with the company’s leftover earnings to effectively implement a residual dividend policy without the negative impact that fluctuating cash dividends may have on the share price.
  3. The company views its own stock as a strong investment.
  4. Management can send a signal to investors that the future outlook for the company is good. This tactic is often used when a share price is declining and management wants to convey confidence in the company’s future to investors.

Management can change the company’s capital structure by decreasing the percentage of equity.

  • The dividend irrelevance theory: Merton Miller and Franco Modigliani (MM) maintain that dividend policy is irrelevant, as it has no effect on the price of a firm’s stock or its cost of capital. MM’s argument of dividend irrelevance is based on their concept of homemade dividends. Assume, for example, that you are a stockholder and you don’t like the firm’s dividend policy. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s stock. If the cash dividend you received was too small, you can just sell a little bit of your stock in the firm to get the cash flow you want. In either case, the combination of your investment in the firm and your cash in hand will be the same.
holds only in a perfect world with no taxes, no brokerage costs, and infinitely divisible shares
pertains to the firm’s dividend policy (payout versus retention) and not the actual payout (current and future cash flow potential).
  • Dividend preference theory: When MM conclude that dividends are irrelevant, they mean that investors don’t care about the firm’s dividend policy since they can create their own. If they don’t care, the firm’s dividend policy will not affect the firm’s stock price, and, consequently, dividend policy will not affect the firm’s required rate of return on equity capital. Myron Gordon and John Lintner, however, argue that rs decreases as the dividend payout increases. Why? Because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current certain dividend payments. The main argument of Gordon and Lintner is that investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of expected capital gains. They base this argument on the fact that, when measuring total return, the dividend yield component, D1/P0, has less risk than the growth component g.
lower cost of equity may lead to a higher price-to-earnings ratio for the firm
  • The tax aversion theory: In the United States and other countries, dividends have historically been taxed at higher rates than capital gains. In the 1970s, tax rates on dividend income were as high as 70% while the tax on capital gains was 35%. In the late 1990s the rates were different, but the relationship was still in place. Dividends were taxed as ordinary income with rates as high as 39.1%, while long-term capital gains were taxed at 20%. According to the tax-aversion theory, investors will prefer to not receive dividends due to their higher tax rates. Taken to the extreme, the tax-aversion theory implies that investors would want companies to have a zero payout ratio so that they will not be burdened with higher tax rates.

Corporate Governance

  • Corporate governance: "the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome conflicts of interest inherent in the corporate form." A company that does not have a sound system of corporate governance in place is taking on a major risk.


  1. Eliminate or reduce conflicts of interest.
  2. Use the company’s assets in a manner consistent with the best interests of investors and other stakeholders.

Effective corporate governance systems

  • Define the rights of shareholders and other important stakeholders.
  • Define and communicate to stakeholders the oversight responsibilities of managers and directors.
  • Provide for fair and equitable treatment in all dealings between managers, directors, and shareholders.
  • Have complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position.

Conflicts of interest

  • Sole proprietorships - no legal distinction between the business and its owners; typically involve creditors and suppliers
  • Partnerships - potential conflicts between partners are typically addressed by creating partnership contracts that delineate the roles and responsibilities of each partner.
  • Corporations - Corporate shareholders typically have no input in day-to-day management of the firm and have difficulty monitoring a firm’s operations and the actions of management. The lack of owner control creates potential conflicts with management and directors.
  • Principal-agent problem: the agent may act for his own well being rather than that of the principal.
    • Managers and shareholders: Shareholders want management to make decisions that maximize shareholder wealth, but managers, left on their own, may well make decisions that maximize their own wealth.
    • Directors and shareholders: directors align more with management interests rather than those of shareholders; e.g. lack of independence, board members have personal relationships with management, board members have consulting or other business agreements with the firm, interlinked boards, or directors are overcompensated.

Board of directors responsibilities

  1. Institute corporate values and corporate governance mechanisms that will ensure business is conducted in a proficient, ethical, and fair manner.
  2. Ensure that the firm meets and complies with all legal and regulatory requirements in a timely manner.
  3. Create long-term strategic objectives for the company that are consistent with the shareholders’ best interests.
  4. Determine management’s responsibilities and how they will be held accountable. Performance should be measured in all areas of a company’s operations.
  5. Hire, appropriately compensate, and regularly evaluate the performance of the chief executive officer (CEO).
  6. Require management to supply the board with complete and accurate information in order for the board to make decisions for which it is responsible and adequately monitor company management.
  7. Meet regularly to conduct its normal business, and meet in extraordinary session if necessary.
  8. Ensure that board members are adequately trained to perform board functions.

Effective corporate governance practices:

  • At least three-quarters of board members should be independent.
  • Have the CEO and Chairman as separate positions.
  • Board members with the requisite industry, strategic planning, and risk management knowledge, not serving on more than two or three boards, and showing a commitment to investor interests and ethical management and investing principles.
  • Annual elections.
  • Evaluate and assess their own effectiveness at least annually.
  • Meet at least annually, preferably quarterly, in separate sessions without management in attendance.
  • The audit committee consists only of independent directors, has expertise in financial and accounting matters, has full access and the cooperation of management, and meets with auditors at least once annually.
  • The nominating committee consists only of independent directors.
  • Have base salary and perquisites as a small percentage of management's compensation, with bonuses, stock options, and grants of restricted stock awarded for exceeding performance goals making up the majority of a senior manager’s income.
  • The board uses independent, outside counsel whenever such legal counsel is required.
  • More disclosure is better.
  • Have insider or related-party transactions approved by the board of directors.

Corporate governance policies subject to assessment:

  • Codes of ethics: Articulates the values, responsibilities, and ethical conduct of an organization.
  • Directors oversight, monitoring, and review responsibilities: These include statements regarding internal controls, risk management, audit and accounting disclosure policies, regulatory compliance, nominations, and compensation.
  • Management’s responsibility to the board: These include management’s responsibility to provide complete and timely information to board members, and to provide directors with direct access to the company’s control and compliance functions.
  • Reports of directors’ oversight and review of management.
  • Board self assessments.
  • Management performance assessments.
  • Director training: Includes training that is provided to directors before they join the board and as well as ongoing training.

Valuation implications

  • Strength and effectiveness of a corporate governance system has a direct and significant impact on the value of a company
  • Strong/effective corporate governance system -> higher measures of profitability and higher returns
  • Weak or ineffective corporate governance system -> increases the risk to an investor -> reducing the value of the company. In extreme cases, deficient governance could cause a company to go bankrupt. Risks of an ineffective corporate system include: Financial disclosure risk, Asset risk, Liability risk, Strategic policy risk

Mergers and Acquisitions

Forms of Integration

  • Statutory merger: The acquiring company acquires all of the target’s assets and liabilities. As a result, the target company ceases to exist as a separate entity.
  • Subsidiary merger: The target company becomes a subsidiary of the purchaser.
  • Consolidation: Both companies cease to exist in their prior form, and they come together to form a completely new company.
  • Forms of Acquisition: A merger transaction may take the form of a stock purchase or an asset purchase. In a stock purchase, the target’s shareholders receive cash or shares of the acquiring company’s stock in exchange for their shares of the target. In an asset purchase, payment is made directly to the target company in return for specific assets.

Types of Mergers

  • Horizontal: The two businesses operate in the same or similar industries, and may often be competitors.
  • Vertical: The acquiring company seeks to move up or down the product supply chain. For example, an ice cream manufacturer decides to acquire a restaurant chain so it can have an outlet for its products and not rely on supermarkets or other restaurants. This is an example of forward integration. If the restaurant chain had acquired the ice cream manufacturer is called backward integration because the company is moving down the supply chain.
  • Conglomerate: The two companies operate in completely separate industries. As such, there are expected to be few, if any, synergies from combining the two companies.

Common motivations:

  • Achieving synergies.
  • More rapid growth.
  • Increasing market power.
  • Gaining access to unique capabilities.
  • Diversification.
  • Personal benefits for managers.
  • Tax benefits.
  • Unlocking hidden value for a struggling company.
  • Achieving international business goals.
  • Bootstrapping earnings.

Bootstrapping is a way of packaging the combined earnings from two companies after a merger so that the merger generates an increase in the earnings per share of the acquirer, even when no real economic gains have been achieved.

  • The bootstrap effect is a technique whereby a high P/E firm acquires a low P/E firm in an exchange of stock. The total earnings of the combined firm are unchanged, but the total shares outstanding are less than the two separate entities.

Different motivations depending on the industry life cycle stage

  • In the pioneer and rapid growth phases, companies look to mergers to provide additional capital or capacity for growth; conglomerate and horizontal mergers are common.
  • In the mature growth and stabilization phases, firms are looking for synergies to reduce costs; horizontal and vertical mergers are common.
  • In the decline phase, companies are typically looking for new growth opportunities to survive; all three merger types are common.

Attitude of Target Management: The target company’s management will either view a merger as being friendly or hostile. In a friendly merger, the acquirer and target work together to perform due diligence and sign a definitive merger agreement before submitting the merger proposal to the target’s shareholders. In a hostile merger, the acquirer seeks to avoid the target’s management through a tender offer or proxy battle.

Defensive mechanisms

  • Pre-offer defense mechanisms taken before a hostile takeover:
    • Poison pill: gives current shareholders the right to purchase additional shares at attractive prices
    • Poison put: gives bondholders option to demand immediate repayment
    • Restrictive takeover laws: seek to reincorporate in a state that has enacted strict anti-takeover laws
    • Staggered board elections: prevents potential acquirer to seize board seats
    • Restricted voting rights: equity ownership above some threshold level triggers a loss of voting
    • Supermajority voting: requires excess of a simple majority
    • Fair price amendments: restricts a merger offer unless a "fair" price is offered
    • Golden parachutes: compensation agreements which gives target company's managers cash payouts if they leave after the merger
  • Post-offer defense mechanisms taken after a hostile takeover:
    • "Just say no" defense: making public case that acquirer's offer is not in the shareholder's best interests
    • Litigation: filing of a lawsuit which puts financial and timely pressure on acquirer
    • Share repurchase: tender offer for own shares
    • Greenmail: buyback of shares from the acquirer at premium
    • Leveraged recapitalization: share repurchases with debt replacement
    • Crown jewel defense: sell a subsidiary or major asset to a neutral third party
    • Pac man defense: making a counteroffer to acquire the acquirer
    • White knight defense: friendly third party comes to the rescue
    • White squire defense: friendly third party buys a minority stake

U.S. antitrust regulation

  • 1890: The Sherman Antitrust Act made any contracts or combinations that attempted to restrain trade or create a monopoly in an industry illegal. The Act was ineffective because the U.S. Department of Justice lacked enough resources to enforce it. Within a few years, the Sherman Act was challenged in the courts and deemed unenforceable due to ambiguous wording.
  • 1914: The Clayton Antitrust Act was passed to improve upon the Sherman Act by detailing specific business practices deemed illegal. In order to enforce the new law, the Federal Trade Commission Act of 1914 was also enacted to create the Federal Trade Commission (FTC) as a regulatory agency to work with the U.S. Department of Justice.
  • 1950: The Celler-Kefauver Act was passed to address weaknesses in the Clayton Act. For example, the Clayton Act only regulated stock purchases, and not asset purchases. Celler-Kefauver closed this loophole and also added new rules to address antitrust behavior pertaining to vertical and conglomerate mergers.
  • 1976: The Hart-Scott-Rodino Antitrust Improvements Act of 1976 required all potential mergers to be reviewed and approved of in advance by the FTC and Department of Justice. Prior to 1976, a merged company had to be dissembled after the fact if the merger was deemed anticompetitive.

Herfindahl-Hirschman Index (HHI) and likelihood of an antitrust challenge

  • HHI index = sum of squared market share of all firms within the industry
Post-merger HHI Industry Concentration Change in Pre-and Post-Merger HHI Antitrust Action
Less than 1,000 Not concentrated Any amount No action
Between 1,000 and 1,800 Moderately concentrated 100 or more Possible antitrust challenge
Greater than 1,800 Highly concentrated 50 or more Antitrust challenge virtually certain

Target company valuation

  • Discounted cash flow analysis based on a pro forma forecast of the target firm’s expected future free cash flows, discounted back to the present. easy to model, highly subject to error
    1. Determine which free cash flow model to use for the analysis: Basic free cash flow models come in two-stage or three-stage varieties.
    2. Develop pro forma financial estimates: These projected financial statements form the estimates that are the basis for our analysis.
    3. Calculate free cash flows using the pro forma data: Starting with net income, we can calculate free cash flows.
    4. Discount free cash flows back to the present at the appropriate discount rate: Usually, this discount rate is simply the target’s weighted average cost of capital (WACC), but in the context of evaluating a potential merger target, we want to adjust the target’s WACC to reflect any changes in the target’s risk or capital structure that may result from the merger (WACCadjusted).
    5. Determine the terminal value and discount it back to the present: The terminal value can be determined in two ways. The first is to use a constant growth model that assumes the company grows in perpetuity at a constant rate. The constant growth formula can be used when the terminal growth rate is less than the discount rate.
    6. The second method applies a market multiple that the analyst believes that the firm will trade at the end of the first stage (e.g., a projected price/free cash flow ratio).
    7. Add the discounted FCF values for the first stage and the terminal value to determine the value of the target firm.
  • Comparable company analysis uses market data from similar firms plus a takeover premium to derive an estimated value for the target; market value derivation, uses historical data, provides an estimate of a fair stock price, but not a fair takeover price
    1. Identify the set of comparable firms: Ideally, the sample will come from the same industry and have a similar size and capital structure.
    2. Calculate various relative value measures based on the current market prices of companies in the sample: Measures based on enterprise value as well as industry specific multiples may be used.
    3. Calculate descriptive statistics for the relative value metrics and apply those measures to the target firm: Analysts will typically calculate the mean, median, and range for the chosen relative value measures and apply those to the estimates for the target to determine the target’s value.
    4. Estimate a takeover premium: To estimate this, analysts usually look at premiums paid in recent takeovers of similar companies.
    5. Calculate the estimated takeover price for the target as the sum of estimated stock value based on comparables and the takeover premium: Once the takeover price is computed, the acquirer should compare it to the estimated synergies from the merger to make sure the price makes economic sense.
  • Comparable transaction analysis uses details from completed M&A deals for companies similar to the target being analyzed to calculate an estimated value for the target; takes takeover premium into account, not enough comparable transactions
    1. Identify a set of recent takeover transactions. Ideally, all of the takeovers will involve firms in the same industry as the target and have a similar capital structure. These sorts of deals can be difficult to find, so the analyst will have to use some judgment as to what recent merger deals are most applicable to the analysis.
    2. Calculate various relative value measures based on completed deal prices for the companies in the sample. The measures used here are the same as those used in comparable company analysis (e.g., P/E, P/CF), but they are based on prices for completed M&A deals rather than current market prices.
    3. Calculate descriptive statistics for the relative value metrics and apply those measures to the target firm. Again, analysts will typically calculate the mean, median, and range for the chosen relative value measures and apply those to the firm statistics for the target to determine the target’s value.

Method of Payment: The method of payment in a merger transaction may be cash, stock, or a combination of the two. Cash offerings are straight forward, but in stock offerings, the exchange ratio determines the number of the acquirer’s shares that each target company shareholder will receive.

  • Cash offer: In a cash offer, the acquirer assumes the risk and receives the potential reward from the merger, while the gain for the target shareholders is limited to the takeover premium. If an acquirer makes a cash offer in a deal, but the synergies realized are greater than expected, the takeover premium for the target would remain unchanged while the acquirer reaps the additional reward. Likewise, if synergies were less than expected, the target would still receive the same takeover premium, but the acquirer’s gain may evaporate.
  • Stock offer: In a stock offer, some of the risks and potential rewards from the merger shift to the target firm. When the target receives stock as payment, the target’s shareholders become a part owner of the acquiring company. This means that if estimates of the potential synergies are wrong, the target will share in the upside if the actual synergies exceed expectations, but will also share in the downside if the actual synergies are below expectations.
  • The main factor that affects the method of payment decision is confidence in the estimate of merger synergies. The more confident both parties are that synergies will be realized, the more the acquirer will prefer to pay cash and the more the target will prefer to receive stock. Conversely, if estimates of synergies are uncertain, the acquirer may be willing to shift some of the risk (and potential reward) to the target by paying for the merger with stock, but the target may prefer the guaranteed gain that comes from a cash deal.

Value gains from merger

  • Vmerger = Vacquirer + Vtarget - cost - synergy
  • Gaintarget = takeover premium = Ptarget - Vtarget
  • Gainacquirer = Synergy - takeover premium

Empirical evidence

  • Short-term performance studies: after merger announcements, targets gain apprx. 30%, acquirers lose stock value of between 1-3%
  • Long-term performance studies show that acquirers tend to underperform their peers

Divestitures refer to a company selling, liquidating, or spinning off a division or subsidiary. Most divestitures involve a direct sale of a portion of a firm to an outside buyer. The selling firm is typically paid in cash and gives up control of the portion of the firm sold.

  • Equity carve-outs create a new, independent company by giving an equity interest in a subsidiary to outside shareholders. Shares of the subsidiary are issued in a public offering of stock, and the subsidiary becomes a new legal entity whose management team and operations are separate from the parent company.
  • Spin-offs are like carve-outs in that they create a new independent company that is distinct from the parent company. The primary difference is that shares are not issued to the public, but are instead distributed proportionately to the parent company’s shareholders. This means that the shareholder base of the spin-off will be the same as that of the parent company, but the management team and operations are completely separate. Since shares of the new company are simply distributed to existing shareholders, the parent company does not receive any cash in the transaction.
  • Split-offs allow shareholders to receive new shares of a division of the parent company in exchange for a portion of their shares in the parent company. The key here is that shareholders are giving up a portion of their ownership in the parent company to receive the new shares of stock in the division.
  • Liquidations break up the firm and sell its asset piece by piece. Most liquidations are associated with bankruptcy.

Reasons for divestitures:

  • Division no longer fits into management’s long-term strategy: no longer a strategic fit, sell for more efficient capital utilization
  • Lack of profitability: poor performance
  • Reverse synergy: Individual parts are worth more than the whole
  • Infusion of cash: Selling a division can create a significant cash inflow for the parent company