Finance Problem Answers

Chapter 25

Mergers, LBOs, Divestitures, and Holding Companies

ANSWERS TO END-OF-CHAPTER QUESTIONS

25-1 a. Synergy occurs when the whole is greater than the sum of its parts. When applied to mergers, a synergistic merger occurs when the postmerger earnings exceed the sum of the separate companies' premerger earnings. A merger is the joining of two firms to form a single firm.

b. A horizontal merger is a merger between two companies in the same line of business. In a vertical merger, a company acquires another firm that is "upstream" or "downstream"; for example, an automobile manufacturer acquires a steel producer. A congeneric merger involves firms that are interrelated, but not identical, lines of business. One example is Prudential's acquisition of Bache & Company. In a conglomerate merger, unrelated enterprises combine, such as Mobil Oil and Montgomery Ward.

c. A friendly merger occurs when the target company's management agrees to the merger and recommends that shareholders approve the deal. In a hostile merger, the management of the target company resists the offer. A defensive merger occurs when one company acquires another to help ward off a hostile merger attempt. A tender offer is the offer of one firm to buy the stock of another by going directly to the stockholders, frequently over the opposition of the target company's management. A target company is a firm that another company seeks to acquire. Breakup value is a firm's value if its assets are sold off in pieces. An acquiring company is a company that seeks to acquire another firm.

d. An operating merger occurs when the operations of two companies are integrated with the expectation of obtaining synergistic gains. These may occur due to economies of scale, management efficiency, or a host of other reasons. In a pure financial merger, the companies will not be operated as a single unit, and no operating economies are expected.

e. The discounted cash flow (DCF) method to valuing a business involves the application of capital budgeting procedures to an entire firm rather than to a single project. The market multiple method applies a market-determined multiple to net income, earnings per share, sales, book value, or number of subscribers, and is a less precise method than DCF.

f. Under purchase accounting, the acquiring firm is assumed to have "bought" the acquired company in much the same way it would buy any capital asset. Any excess of the purchase price over the book value of assets is added to goodwill, which may be expensed for Federal income tax purposes, but may not be expensed for shareholder reporting.

g. A white knight is a friendly competing bidder that a target management likes better than the company making a hostile offer, and the target solicits a merger with the white knight as a preferable alternative.

A poison pill is a deliberate action that a company takes which makes it a less attractive takeover target. A golden parachute is a payment made to executives that are forced out when a merger takes place. A proxy fight is an attempt to gain control of a firm by soliciting stockholders to vote for a new management team.

h. A joint venture involves the joining together of parts of companies to accomplish specific, limited objectives. Joint ventures are controlled by the combined management of the two (or more) parent companies. A corporate or strategic alliance is a cooperative deal that stops short of a merger.

i. A divestiture is the opposite of an acquisition. That is, a company sells a portion of its assets, often a whole division, to another firm or individual. In a spin-off, a holding company distributes the stock of one of the operating companies to its shareholders. Thus, control passes from the holding company to the shareholders directly. A leveraged buyout is a transaction in which a firm's publicly owned stock is acquired in a mostly debt-financed tender offer, and a privately owned, highly leveraged firm results. Often, the firm's own management initiates the LBO.

j. A holding company is a corporation formed for the sole purpose of owning stocks in other companies. A holding company differs from a stock mutual fund in that holding companies own sufficient stock in their operating companies to exercise effective working control. An operating company is a company controlled by a holding company. A parent company is another name for a holding company. A parent company will often have control over many subsidiaries.

k. Arbitrage is the simultaneous buying and selling of the same commodity or security in two different markets at different prices, and pocketing a risk-free return. In the context of mergers, risk arbitrage refers to the practice of purchasing stock in companies that may become takeover targets.

25-2 Horizontal and vertical mergers are most likely to result in governmental intervention, but mergers of this type are also most likely to result in operating synergy. Conglomerate and congeneric mergers are attacked by the government less often, but they also are less likely to provide any synergistic benefits.

25-3 A tender offer might be used. Although many tender offers are made by surprise and over the opposition of the target firm's management, tender offers can and often are made on a "friendly" basis. In this case, management (the board of directors) of the target company endorses the tender offer and recommends that shareholders tender their shares.

25-4 An operating merger involves integrating the company's operations in hopes of obtaining synergistic benefits, while a pure financial merger generally does not involve integrating the merged company's operations.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

25-1 FCF1 = 2.00(1.05) = $2.1 million; g = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd = 30%; T = 40%; rd = 8% Vops = ? P0 = ?

rs = rRF + RPM(b)

= 5% + 6%(1.4)

= 13.4%.

WACC = wdrd(1-T) + wsrs

= 0.30(8%)(0.60) + 0.70(13.4%)

= 10.82%

Vops =

=

= $36.08 million

VS =