Fundamentals of Financial Management
SELF-TEST QUESTIONS AND PROBLEMS
(Solutions Appear in Appendix A)
ST-1 Key terms Define each of the following terms:
a. Synergy; merger
b. Horizontal merger; vertical merger; congeneric merger; conglomerate merger
c. Friendly merger; hostile merger; defensive merger; tender offer; target company;
breakup value; acquiring company
d. Operating merger; financial merger; equity residual method; market multiple analysis
e. White knight; white squire; poison pill; golden parachute; proxy fight
f. Joint venture; corporate alliance
g. Divestiture; spin-off; leveraged buyout (LBO); carve-out; liquidation
h. Arbitrage
i. Goodwill; purchase method
ST-2 Merger value Pizza Place, a national pizza chain, is considering purchasing a smaller chain, Western Mountain Pizza. Pizza Place’s analysts project that the merger will result in incremental net cash flows of $1.5 million in Year 1, $2 million in Year 2, $3 million in Year 3, and $5 million in Year 4. In addition, Western’s Year 4 cash flows are expected to grow at a constant rate of 5 percent after Year 4. Assume all cash flows occur at the end of the year. The acquisition would be made immediately, if it were undertaken. Western’s post-merger beta is estimated to be 1.5, and its post-merger tax rate would be 4
The risk-free rate is 6 percent, and the market risk premium is 4 percent. What is the value of Western Mountain Pizza to Pizza Place?
QUESTIONS
21-1 Four economic classifications of mergers are (1) horizontal, (2) vertical, (3) conglomerate, and (4) congeneric. Explain the significance of these terms in merger analysis with regard to
(a) the likelihood of governmental intervention and (b) possibilities for operating synergy.
21-2 Firm A wants to acquire Firm B. Firm B’s management agrees that the merger is a good idea. Might a tender offer be used?
21-3 Distinguish between operating mergers and financial mergers.
21-4 In the spring of 1984, Disney Productions’ stock was selling for about $3.125 per share (all prices have been adjusted for 4-for-1 splits in 1986 and 1992). Then Saul Steinberg, a New York financier, began acquiring it, and after he had 12 percent, he announced a tender offer for another 37 percent of the stock—which would bring his holdings up to 49 percent—at a price of $4.22 per share. Disney’s management then announced plans to buy Gibson Greeting Cards and Arvida Corporation, paying for them with stock. It also lined up bank credit and (according to Steinberg) was prepared to borrow up to $2 billion and use the funds to repurchase shares at a higher price than Steinberg was offering. All of these efforts were designed to keep Steinberg from taking control. In June, Disney’s management agreed to pay Steinberg $4.84 per share, which gave him a gain of about $60 million on a 2-month investment of about $26.5 million.
When Disney’s buyback of Steinberg’s shares was announced, the stock price fell almost instantly from $4.25 to $2.875. Many Disney stockholders were irate, and they sued to block the buyout. Also, the Disney affair added fuel to the fire in a congressional committee that was holding hearings on proposed legislation that would (1) prohibit someone from acquiring more than 10 percent of a firm’s stock without making a tender offer for all the remaining shares, (2) prohibit poison pill tactics such as those Disney’s management had used to fight off Steinberg, (3) prohibit buybacks such as the deal eventually offered to Steinberg (greenmail) unless there was an approving vote by stockholders, and (4) prohibit (or substantially curtail) the use of golden parachutes (the one thing Disney’s management did not try).
Set forth the arguments for and against this type of legislation. What provisions, if any, should it contain? Also, look up Disney’s current stock price to see how its stock- holders have actually fared. Note that Disney’s stock was split 3-for-1 in July 1998.
21-5 Two large, publicly owned firms are contemplating a merger. No operating synergy is expected. However, since returns on the 2 firms are not perfectly positively correlated, the standard deviation of earnings would be reduced for the combined corporation. One group of consultants argues that this risk reduction is sufficient grounds for the merger.
Another group thinks this type of risk reduction is irrelevant because stockholders can themselves hold the stock of both companies and thus gain the risk-reduction benefits without all the hassles and expenses of the merger. Whose position is correct? Explain.
PROBLEMS
The following information is required to work Problems 21-1, 21-2, and 21-3. Harrison Corporation is interested in acquiring Van Buren Corporation. Assume that the risk-free rate of interest is 5 percent and the market risk premium is 6 percent.
21-1 Valuation Van Buren currently expects to pay a year-end dividend of $2.00 a share (D 1 =
$2.00). Van Buren’s dividend is expected to grow at a constant rate of 5 percent a year, and its beta is 0.9. What is the current price of Van Buren’s stock?
21-2 Merger valuation Harrison estimates that if it acquires Van Buren, the year-end dividend will remain at $2.00 a share, but synergies will enable the dividend to grow at a constant rate of 7 percent a year (instead of the current 5 percent). Harrison also plans to increase the debt ratio of what would be its Van Buren subsidiary—the effect of this would be to raise Van Buren’s beta to 1.1. What is the per-share value of Van Buren to Harrison C
21-3 Merger bid On the basis of your answers to Problems 21-1 and 21-2, if Harrison were to acquire Van Buren, what would be the range of possible prices that it could bid for each share of Van Buren common stock?
21-4 Merger analysis Apilado Appliance Corporation is considering a merger with the Vaccaro Vacuum Company. Vaccaro is a publicly traded company, and its current beta is
1.30. Vaccaro has been barely profitable, so it has paid an average of only 20 percent in taxes during the last several years. In addition, it uses little debt, having a debt ratio of just 25 percent.
If the acquisition were made, Apilado would operate Vaccaro as a separate, wholly owned subsidiary. Apilado would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35 percent. Apilado also would increase the debt capitalization in the Vaccaro subsidiary to 40 percent of assets, which would increase its beta to 1.47. Apilado’s acquisition department estimates that Vaccaro, if acquired, would produce the following net cash flows to Apilado’s shareholders (in millions of dollars):
Year Net Cash Flows
1 $1.30
2 1.50
3 1.75
4 2.00
5 and beyond Constant growth at 6%
These cash flows include all acquisition effects. Apilado’s cost of equity is 14 percent, its beta is 1.0, and its cost of debt is 10 percent. The risk-free rate is 8 percent.
a. What discount rate should be used to discount the estimated cash flows? (Hint: Use Apilado’s r s to determine the market risk premium.)
b. What is the dollar value of Vaccaro to Apilado?
c. Vaccaro has 1.2 million common shares outstanding. What is the maximum price per share that Apilado should offer for Vaccaro? If the tender offer is accepted at this price, what will happen to Apilado’s stock price?
21-5 Capital budgeting analysis The Stanley Stationery Shoppe wishes to acquire The Carlson Card Gallery for $400,000. Stanley expects the merger to provide incremental earnings of about $64,000 a year for 10 years. Ken Stanley has calculated the marginal cost of capital for this investment to be 10 percent. Conduct a capital budgeting analysis for Stanley to determine whether or not he should purchase The Carlson Card Gallery.
21-6 Merger analysis TransWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Georgia Cable Company (GCC), a regional cable company. TransWorld’s analysts project the following post-merger data for GCC (in thousands of dollars):
2006 2007 2008 2009
Net sales $450 $518 $555 $600
Selling and administrative
expense 45 53 60 68
Interest 18 21 24 27
Tax rate after merger 35%
Cost of goods sold as a
percent of sales 65%
Beta after merger 1.50
Risk-free rate 8%
Market risk premium 4%
Terminal growth rate of cash flow available to TransWorld 7%
If the acquisition is made, it will occur on January 1, 2006. All cash flows shown in the income statements are assumed to occur at the end of the year. GCC currently has a capital structure of 40 percent debt, but TransWorld would increase that to 50 percent if the acquisition were made. GCC, if independent, would pay taxes at 20 percent, but its income would be taxed at 35 percent if it were consolidated. GCC’s current market- determined beta is 1.40, and its investment bankers think that its beta would riseif the debt ratio were increased to 50 percent. The cost of goods sold is expected to be 65 percent of sales, but it could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to TransWorld’s shareholders. The risk-free rate is 8 percent, and the market risk premium is 4 percent.
a. What is the appropriate discount rate for valuing the acquisition?
b. What is the terminal value? What is the value of GCC to TransWorld?
COMPREHENSIVE/SPREADSHEET PROBLEM
21-7 Merger analysis Use the spreadsheet model to rework Problem 21-6, and then answer the following question:
c. Suppose GCC has 120,000 shares outstanding. What is the maximum per-share price TransWorld should offer for GCC?
