Module I: Investment Banking: Mergers and Acquisitions by hfwvCf

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									           Module I: Investment Banking:
            Mergers and Acquisitions
                  Week 4 –September 16 and 18, 2002




J. K. Dietrich - FBE 432 – Spring, 2002
   Motivation
             Many      companies are in the process of
                 restructuring
                  – What are the major forms of restructuring?
                  – What motivates corporate restructuring?
                  – What are the consequences for investors and
                    for firms?




J. K. Dietrich - FBE 432 – Spring, 2002
   Overview of Restructuring
             Two           Major Forms
                  – Expansion (Combining assets through M&A)
                  – Contraction (Breaking-up assets through
                    divestitures etc.)
                  – Other Forms
                        » Changing ownership structure (LBOs, buybacks,
                          etc.) and retaining control through defensive
                          strategies (Poison pills etc.)



J. K. Dietrich - FBE 432 – Spring, 2002
     Expansion: Mergers & Acquisitions
             Merger:                     the absorption of one firm by
              another
             Acquisitions: purchase of a firm’s voting
              stock (tender offer)
             Takeovers: Transfer of control from one
              group of shareholders to another
                  – by merger, stock acquisition, asset acquisition,
                    proxy contest or by going private

J. K. Dietrich - FBE 432 – Spring, 2002
   Acquisition or Merger?
             Stock    acquisitions do not require
                 shareholder meetings or votes, and are
                 frequently hostile
                  – The acquirer deals directly with target’s
                    shareholders, bypassing management
                  – Minority shareholders may hold out in tender
                    offers; complete absorption requires a merger



J. K. Dietrich - FBE 432 – Spring, 2002
   What Explains M&A Activity?
             The    stated objective of all mergers and
                 acquisitions is the creation of value
                  – Other objectives - e.g., managerial hubris - may
                    also play a role but are usually not the stated
                    rationale for an acquisition.
             What            are the sources of value? Two types:
                  – Strategic
                  – Financial


J. K. Dietrich - FBE 432 – Spring, 2002
       Strategic Sources of Value
        1. Under-managed Target
              - Look for strategic and operating errors that can
                be corrected by replacing bad management
        2. Efficiency Gain or Synergies
              - Reduce costs through economies of scale and
                scope in production, finance, research,
                marketing, and through other indivisibilities
              - Increase demand or raise product prices
                through gains in market power

J. K. Dietrich - FBE 432 – Spring, 2002
   Strategic Sources of Value

            3. Opportunities for restructurings
                  – Divest or liquidate businesses with poor fit or
                    poor results
                  – Sell unproductive assets that are retained by
                    managers who cannot or will not shed such
                    value destroying businesses




J. K. Dietrich - FBE 432 – Spring, 2002
   Financial Sources of Value
            Target is undervalued
                  – Markets are inefficient
                        » Forecasted improvements or changes are not
                          reflected in the stock price
                  – Unused gains from the use or sale of
                    accumulated tax losses from net operating
                    losses
                  – Unused debt capacity (“Leverage Bargain”)


J. K. Dietrich - FBE 432 – Spring, 2002
   Bad Reasons for Acquisitions
             Diversification:
                  – However, shareholders can diversify their own
                    holdings at lower cost and greater efficiency
                    through the financial markets.
             Securing                    access to inputs or sales of
                 output
                  – This may be valid, but presumes there are
                    inefficient or uncompetitive markets


J. K. Dietrich - FBE 432 – Spring, 2002
   Bad Reasons for Acquisitions
             Creating                    the Appearance of Growth:
                  – Growth for its own sake does not create value
             Use of Excess Cash:
             Increased EPS:
                  – By buying companies with higher EPS than
                    your own you raise your EPS. Naive investors
                    may believe this to be “growth” even if this
                    destroys value


J. K. Dietrich - FBE 432 – Spring, 2002
   Example of EPS Growth Strategy
             Company   A has 1,000 shares outstanding
              and EPS of $1
             Company B has 500 shares outstanding and
              EPS of $2
             A buys B and now reports higher EPS of
              $1.33
             If A paid more than B was worth, A’s
              shareholders lost although A’s EPS rose

J. K. Dietrich - FBE 432 – Spring, 2002
   Higher EPS Strategy
                                              Company A’s
                                              reported EPS
             Company A acquires B             after
                                              acquisition of
                                              company B
               EPS




                 A                        B        A
J. K. Dietrich - FBE 432 – Spring, 2002
   Are Mergers Beneficial to Society?
             Mergers     and acquisitions are usually
                 associated with layoffs and downsizing.
                  – This may or may not be associated with
                    increased economic efficiency.
             But    M&A activity may facilitate exit from
                 an industry where there is overcapacity




J. K. Dietrich - FBE 432 – Spring, 2002
   Basic Argument
             Suppose   that there are three firms whose
                 minimum efficient scale is 100 units

        Average Cost
                                               Efficient
                                               Production
                                               Zone

                                                                       Price


                                          67    100         Quantity
J. K. Dietrich - FBE 432 – Spring, 2002
   Example
                       industry demand was 300 units, so
             Initially,
              there was no over capacity
             Now, demand has fallen to 200 and is not
              expected to recover
             Each firm produces 67 units, and makes
              economic losses
             The problem: If firm A exits, the benefits
              are captured by B and C

J. K. Dietrich - FBE 432 – Spring, 2002
   Solution
             Since  the benefits from exit do not accrue to
              the exiting firm, each firm fights to stay on,
              causing losses for all firms
             Solution: If B (or C) were to takeover A,
              the shareholders of A would capture the
              external benefits from exit
             In this sense, M&A activity is beneficial to
              society.

J. K. Dietrich - FBE 432 – Spring, 2002
   Empirical Evidence
             In reality, most acquirers fare poorly with
              modest declines in value
             Targets receive most of the benefits of the
              usually substantial run-up in price
              associated with a takeover.




J. K. Dietrich - FBE 432 – Spring, 2002
  Example: Kodak and Sterling Drug
             January   4, 1988: Hoffman LaRoche offers
              $72 per share for Sterling Drug
             January 18: Facing resistance, Hoffman
              raises the offer to $81 per share
             January 22: Kodak announces a friendly
              bid of $89.50 per share for Sterling Drug



J. K. Dietrich - FBE 432 – Spring, 2002
   Price Reaction
             Estimate  Kodak’s return net of the return
              predicted by CAPM
             The abnormal return is the actual return on
              day t less the expected return
             From CAPM, the expected return is



                         E[rt ]  rf ,t   (rm,t  rf ,t )

J. K. Dietrich - FBE 432 – Spring, 2002
   Cumulative Abnormal Returns
                 10%


                   5%


                   0%


                  -5%


                 -10%


                 -15%


                 -20%


                 -25%




                          12/2/87         1/22/88   3/18/88


J. K. Dietrich - FBE 432 – Spring, 2002
   Kodak Paid a High Premium
           Value of Kodak’s Bid           $5.1
           (in billions)

           Less Sterling’s market
           capitalization                 $3.0
           (30 days prior to
           announcement)
           Equals Kodak’s Premium         $2.1


J. K. Dietrich - FBE 432 – Spring, 2002
   ..But Investors Were Skeptical
             Kodak’s   market decrease was about $2.2
              billion, almost the amount of the premium
              paid for Sterling
             Clearly, investors did not believe the deal
              could add value. Why?
                  – Kodak’s past acquisitions were failures and it
                    was ignoring its core business



J. K. Dietrich - FBE 432 – Spring, 2002
   Why Do Acquires Fare Poorly?
         Overbidding
              – Over-optimism or Winner’s Curse
              – Managerial hubris
                    » Mergers increase firm size and hence managerial
                      compensation, without adding value
         Poor          fit between buyer and seller
              – Clash of corporate cultures
         Ignorance  of target’s industry
         Failure to integrate operations carefully and
          fast
J. K. Dietrich - FBE 432 – Spring, 2002
   Example of Winner’s Curse
             Four companies bid for mineral rights on
              Federal land
             True value is $100 million
             Each company estimates value imperfectly
             Valuations are unbiased, but noisy




J. K. Dietrich - FBE 432 – Spring, 2002
   Valuations
             Company A:                  Estimated Value is 80m
             Company B:                  Estimated Value is 90m
             Company C:                  Estimated Value is 110m
             Company D:                  Estimated Value is 120m
                  – Average estimate is correct




J. K. Dietrich - FBE 432 – Spring, 2002
   Bidding
             Second  price, sealed bid auction
             The optimal strategy is to bid your
              reservation price
             Company D bids $120, and wins, paying
              $110
             Winner’s curse: Overpay by 10%




J. K. Dietrich - FBE 432 – Spring, 2002
   Can this be an explanation?
             Winner’s  curse can explain over bidding in
              this simple one-shot game
             But in a repeated game, firms will recognize
              this problem or learn from other’s bids
             However, if takeovers are isolated events,
              the winner’s curse may still hold



J. K. Dietrich - FBE 432 – Spring, 2002
   II. Contractions
             In the 1980s and 1990s, firms that operate
              in fewer numbers of industries do better
              than widely diversified firms.
             Restructurings that result in more focus are
              rewarded by higher stock prices
                  – Example: Dun & Bradstreet, a major
                    information provider, split in three. The stock
                    price reaction was positive, with a subsequent
                    rise of 8%

J. K. Dietrich - FBE 432 – Spring, 2002
   Why is Re-Focusing in Vogue?
             Corporations                made several errors including
                  – Expanding into industries they didn't know
                  – Overestimating the gains from synergy and
                    diversification
                  – Complex structures allowed mistakes to go
                    undetected
                  – Internal conflicts arose over the allocation of
                    capital and direction of future projects


J. K. Dietrich - FBE 432 – Spring, 2002
   Types of Contractions
             Spin-offs:     Creates a new legal entity;
                 shares are distributed on a pro rata basis to
                 parent’s shareholders:
                  – Separation of control over time without cash
                    flows. Example: In 1995, US West spun off its
                    cable and cellular businesses.
             Split-off:    some shareholders get stock in a
                 subsidiary in exchange for parent stock
                  – Immediate separation of control
J. K. Dietrich - FBE 432 – Spring, 2002
   Spin-Offs
                                          Previous shareholders


                   Original Firm


                                              New Firms




                A Spin-Off does not yield cash inflows
J. K. Dietrich - FBE 432 – Spring, 2002
   Motivations for Spin-Offs
             In    recent years, spin-offs and split offs have
                 become increasingly popular as companies
                 try to “refocus” on their core business
                  – Example:
                        » ATT split up into three entities in 1995; NCR,
                          Lucent Technologies and ATT




J. K. Dietrich - FBE 432 – Spring, 2002
   Contraction: Divestitures
             Divestitures:               Sale of part of the firm to
              outsiders
             Equity Carve-outs: Sale of stock in
              subsidiary to outsiders
                  – In both cases, there is an immediate separation
                    of ownership and control
                  – The parent also receives cash inflows



J. K. Dietrich - FBE 432 – Spring, 2002
   Divestitures

              Firm                        Assets




                                           Cash
                Original                            New
                Owners                             Owners


                Divestiture is a Sale of part of the Firm

J. K. Dietrich - FBE 432 – Spring, 2002
   Example: VLSI and Compass
             In 1997, VLSI Technology, a San Jose
              based semiconductor firm had a wholly-
              owned subsidiary, Compass.
             Compass developed CAD/CAM-type
              software to design new computer chips
             Compass licenses its software for profit; the
              parent company, VLSI, receives a
              substantial price discount

J. K. Dietrich - FBE 432 – Spring, 2002
   Example: VLSI and Compass
             VLSI    argues that divesting compass would
              result in higher input costs for itself, putting
              it at a competitive disadvantage.
             But Compass executives believed that as an
              independent company, it could license its
              software to many other chip manufacturers
              who are currently unwilling to pay a
              subsidiary of their rival

J. K. Dietrich - FBE 432 – Spring, 2002
   What Should VLSI Do?
           If  Compass is correct, a split-off would
              have the following effects:
                – Compass’ value would increase
                      » It could charge VLSI more
                      » It could sell more to other chip makers
                – The new VLSI would be worth less
                      » It would have to pay Compass market prices for
                        software products




J. K. Dietrich - FBE 432 – Spring, 2002
   Case: Outcome
             Since the extra costs paid by VLSI upon
              divestiture are equal to the extra revenues
              of Compass, shareholders are no better or
              worse off
             But since Compass will have new sales,
              shareholders would benefit from divestiture
                                 VLSI sold Compass in 1997


J. K. Dietrich - FBE 432 – Spring, 2002
   Conclusions
             Corporate                   restructurings can take many
              forms.
             Restructurings are motivated by the creation
              of value
             But in practice, evidence suggests that
              strategic and financial motives for
              acquisition rarely produce value gains.


J. K. Dietrich - FBE 432 – Spring, 2002
   Next Week – September 23 and 25
             Allocate  tasks associated with group write-
              up and do necessary work
             Hand in Red October case write-up at the
              beginning of class on September 23, 2002
             Review contents of Chapter 19
             Read and begin to identify critical financial
              issues in the John Case Case discussed in
              week 6

J. K. Dietrich - FBE 432 – Spring, 2002

								
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