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578 SECTION SIX


Question 1. Why would Cislunar and Targetco be worth more together than apart?
Suppose that operating costs can be reduced by combining the companies™ marketing,
distribution, and administration. Revenues can also be increased in Targetco™s region.
The rightmost column of Table 6.3 contains projected revenues, costs, and earnings for
the two firms operating together: annual operating costs postmerger will be $2 million
less than the sum of the separate companies™ costs, and revenues will be $2 million
more. Therefore, projected earnings increase by $4 million.5 We will assume that the in-
creased earnings are the only synergy to be generated by the merger.
The economic gain to the merger is the present value of the extra earnings. If the
earnings increase is permanent (a level perpetuity), and the cost of capital is 20 percent,
4
Economic gain = PV (increased earnings) = = $20 million
.20
This additional value is the basic motivation for the merger.

Question 2. What are the terms of the merger? What is the cost to Cislunar and its
shareholders?
Targetco™s management and shareholders will not consent to the merger unless they
receive at least the stand-alone value of their shares. They can be paid in cash or by new
shares issued by Cislunar. In this case we are considering a cash offer of $19 per Tar-
getco share, $3 per share over the prior share price. Targetco has 2.5 million shares out-
standing, so Cislunar will have to pay out $47.5 million, a premium of $7.5 million over
Targetco™s prior market value. On these terms, Targetco stockholders will capture $7.5
million out of the $20 million gain from the merger. That ought to leave $12.5 million
for Cislunar.
This is confirmed in the Cash Purchase column of Table 6.4. Start at the bottom of
the column, where the total market value of the merged firms is $492.5 million. This is
derived as follows:
Cislunar market value prior to merger $480 million
Targetco market value 40
Present value of gain to merger 20
Less Cash paid out to Targetco shareholders “47.5
Postmerger market value $492.5 million

TABLE 6.4
Cash Purchase Exchange of Shares
Financial forecasts after the
Cislunar“Targetco merger. Earnings $ 40 $ 40
The left column assumes a
Cash $ 10 $ 57.5
cash purchase at $19 per
Other assets™ book value 202 202
Targetco share. The right
Total assets $212 $259.5
column assumes Targetco
Price per share $ 49.25 $ 49.85
stockholders receive one new
Number of shares 10.0 10.833
Cislunar share for every
Market value $492.5 $540
three Targetco shares.

Note: Figures in millions except price per share.

5 Tokeep things simple, the example ignores taxes and assumes that both companies are all-equity financed.
We also ignore the interest income that could have been earned by investing the cash used to finance the
merger.
Mergers, Acquisitions, and Corporate Control 579


The postmerger share price for Cislunar will be $49.25, an increase of $1.25 per share.
There are 10 million shares now outstanding, so the total increase in the value of Cis-
lunar shares is $12.5 million.
Now let™s summarize. The merger makes sense for Cislunar for two reasons. First, the
merger adds $20 million of overall value. Second, the terms of the merger give only $7.5
million of the $20 million overall gain to Targetco™s stockholders, leaving $12.5 million
for Cislunar. You could say that the cost of acquiring Targetco is $7.5 million, the differ-
ence between the cash payment and the value of Targetco as a separate company.
Cost = cash paid out “ Targetco value = $47.5 “ 40 = $7.5 million
Of course the Targetco stockholders are ahead by $7.5 million. Their gain is your cost.
As we™ve already seen, Cislunar stockholders come out $12.5 million ahead. This is the
merger™s NPV for Cislunar:
NPV = economic gain “ cost = $20 “ 7.5 = $12.5 million
Writing down the economic gain and cost of a merger in this way separates the mo-
tive for the merger (the economic gain, or value added) from the terms of the merger
(the division of the gain between the two merging companies).


Killer Shark Inc. makes a surprise cash offer of $22 a share for Goldfish Industries. Be-
Self-Test 3
fore the offer, Goldfish was selling for $18 a share. Goldfish has 1 million shares out-
standing. What must Killer Shark believe about the present value of the improvement it
can bring to Goldfish™s operations?



MERGERS FINANCED BY STOCK
What if Cislunar wants to conserve its cash for other investments, and therefore decides
to pay for the Targetco acquisition with new Cislunar shares? The deal calls for Targetco
shareholders to receive one Cislunar share in exchange for every three Targetco shares.
It™s the same merger, but the financing is different. The right column of Table 6.4
works out the consequences. Again, start at the bottom of the column. Note that the mar-
ket value of Cislunar™s shares after the merger is $540 million, $47.5 million higher than
in the cash deal, because that cash is kept rather than paid out to Targetco shareholders.
On the other hand, there are more shares outstanding, since 833,333 new shares have to
be issued in exchange for the 2.5 million Targetco shares (a 1 to 3 ratio). Therefore, the
price per share is 540/10.833 = $49.85, which is 60 cents higher than in the cash offer.
Why do Cislunar stockholders do better from the share exchange? The economic
gain from the merger is the same, but the Targetco stockholders capture less of it. They
get 833,333 shares at $49.85, or $41.5 million, a premium of only $1.5 million over
Targetco™s prior market value.
Cost = value of shares issued “ Targetco value
= $41.5 “ 40 = $1.5 million
The merger™s NPV to Cislunar™s original shareholders is
NPV = economic gain “ cost = 20 “ 1.5 = $18.5 million
Note that Cislunar stock rises by $1.85 from its prior value. The total increase in value
for Cislunar™s original shareholders, who retain 10 million shares, is $18.5 million.
580 SECTION SIX


Evaluating the terms of a merger can be tricky when there is an exchange of shares.
The target company™s shareholders will retain a stake in the merged firms, so you have
to figure out what the firm™s shares will be worth after the merger is announced and its
benefits appreciated by investors. Notice that we started with the total market value of
Cislunar and Targetco postmerger, took account of the merger terms (833,333 new
shares issued), and worked back to the postmerger share price. Only then could we work
out the division of the merger gains between the two companies.
There is a key distinction between cash and stock for financing mergers. If cash is
offered, the cost of the merger is not affected by the size of the merger gains. If stock is
offered, the cost depends on the gains because the gains show up in the post-merger
SEE BOX share price, and these shares are used to pay for the acquired firm. The nearby box il-
lustrates how complex a stock offer can be. When Gillette offered to buy Duracell, giv-
ing Duracell shareholders about a 20 percent stake in the merged firm, the attractive-
ness of the deal depended on the stock market™s valuation of both firms.
Stock financing also mitigates the effects of over- or undervaluation of either firm.
Suppose, for example, that A overestimates B™s value as a separate entity, perhaps be-
cause it has overlooked some hidden liability. Thus A makes too generous an offer.
Other things equal, A™s stockholders are better off if it is a stock rather than a cash offer.
With a stock offer, the inevitable bad news about B™s value will fall partly on B™s for-
mer stockholders.


Suppose Targetco shareholders demand one Cislunar share for every 2.5 Targetco
Self-Test 4
shares. Otherwise they will not accept the merger. Under these revised terms, is the
merger still a good deal for Cislunar?



A WARNING
The cost of a merger is the premium the acquirer pays for the target firm over its value
as a separate company. If the target is a public company, you can measure its separate
value by multiplying its stock price by the number of outstanding shares. Watch out,
though: if investors expect the target to be acquired, its stock price may overstate the
company™s separate value. The target company™s stock price may already have risen in
anticipation of a premium to be paid by an acquiring firm.

ANOTHER WARNING
Some companies begin their merger analyses with a forecast of the target firm™s future
cash flows. Any revenue increases or cost reductions attributable to the merger are in-
cluded in the forecasts, which are then discounted back to the present and compared
with the purchase price:
Estimated net gain = DCF valuation of target including merger benefits
“ cash required for acquisition
This is a dangerous procedure. Even the brightest and best-trained analyst can make
large errors in valuing a business. The estimated net gain may come up positive not be-
cause the merger makes sense, but simply because the analyst™s cash-flow forecasts are
too optimistic. On the other hand, a good merger may not be pursued if the analyst fails
to recognize the target™s potential as a stand-alone business.
FINANCE IN ACTION

Blades, Batteries, and a Fifth of Gillette
Back in 1988, when Kraft Inc. decided to unload its bat-
tery subsidiary, Gillette Co. was tempted. But the bid- Gillette™s Stock
ding went up and up and out of Gillette™s reach.
$80
Kohlberg Kravis Roberts & Co. eventually bought the




Daily closing price
battery maker” it was Duracell, of course” for a seem- 60
ingly extravagant $1.8 billion.
After eight years of due diligence, Gillette has finally 40
agreed to fork over stock valued at more than $7 billion
for the very same Duracell International Inc. Just as 20
KKR now looks shrewd, rear-view analysts may snicker
0
at Gillette for buying dear what it could have had then
1988 1989 1990 1991 1992 1993 1994 1995 1996
for, let us assume, only $2 billion in stock.
In fact, Gillette shareholders should thank their lucky
stars the earlier deal didn™t happen. In share-for-share
shareholder is trading away one-fifth of his interest in
acquisitions, what you are getting is only half the pic-
the old Gillette. Whether Duracell will be worth it, a sub-
ture; what you are giving up is just as important. The
ject no analyst has addressed, is what matters.
standard analysis values such deals according to the
Such deals are manna for investment bankers (and
dollar value of the target, but that approach is flawed.
bound to wind up in B-school texts) because you need
The key question isn™t whether Duracell is worth $7 bil-
to size up two businesses instead of one.
lion, because Gillette isn™t giving up $7 billion. It is giv-
On balance, the blade business is more distinct, and
ing up a part” in this case 20%” of itself.
better, than batteries. But how much better? Duracell
Schematically, Gillette is trading razor blades for bat-
for one-fifth of Gillette works out to this: For each dollar
teries (not bucks for batteries), and the results can be
of Gillette earnings that shareholders are giving up, they
very different. Since 1988, for instance, the blade busi-
are getting roughly $1.30 in cash earnings from batter-
ness, at least under Gillette™s management, has per-
ies.
formed much better than batteries. While Duracell™s
Blades should trade at a premium, but this one is
stock has quadrupled, Gillette™s has multiplied eight
steep. That premium, of course, reflects the current
times. Thus if Gillette had in fact made that “ cheap” $2
very high price of Gillette™s stock, which in turn reflects
billion acquisition, it would have acquired a jack rabbit
a view that Gillette will forever keep profit growing twice
but given up a prize thoroughbred. The passed-over
as fast as its sales. Gillette™s managers wouldn™t come
purchase back then would have cost Gillette more than
out and say that 34 times earnings reflects unwarranted
one-third of its stock; today, it is buying the same busi-
optimism, or even a bull-market joie de vivre, but if that
ness for only a fifth of its stock.
is what they thought, trading part of their company at
Clearly, taking a pass was the right move. Duracell
that price for a cheaper one would be a smart move.
was cheap in 1988, but Gillette was cheaper. And shop-
And that is what they are doing.
ping with inexpensive currency, meaning issuing under-
valued stock, amounts to selling the company (or a
Source: Republished with permission of Dow Jones, from “Blades,
piece of it) on the cheap. Batteries, and a Fifth of Gillette,” from R. Lowenstein, “Intrinsic
Going forward, the same analysis holds. The im- Value,” The Wall Street Journal, September 19, 1996, p. C1; permis-
puted dollar value of the deal will forever drift with sion conveyed through Copyright Clearance Center.
Gillette™s share price; the one constant is that each



A better procedure starts with the target™s current and stand-alone market value and
concentrates instead on the changes in cash flow that would result from the merger. Al-
ways ask why the two firms should be worth more together than apart. Remember, you
add value only if you can generate additional economic benefits”some competitive

581
582 SECTION SIX


edge that other firms can™t match and that the target firm™s managers can™t achieve on
their own.
It makes sense to keep an eye on the value that investors place on the gains from merg-
ing. If A™s stock price falls when the deal is announced, investors are sending a message
that the merger benefits are doubtful or that A is paying too much for these benefits.



Merger Tactics
In recent years, most mergers have been agreed upon by both parties, but occasionally,
an acquirer goes over the heads of the target firm™s management and makes a tender
offer directly to its stockholders. The management of the target firm may advise share-
holders to accept the tender, or it may attempt to fight the bid in the hope that the ac-
quirer will either raise its offer or throw in the towel.
The rules of merger warfare are largely set by federal and state laws6 and the courts
act as referee to see that contests are conducted fairly. We will look at one recent con-
test that illustrates the tactics and weapons employed. Outside the English-speaking
countries hostile takeovers once were rare. But the world is changing, and the nearby
box describes a recent takeover battle between Italian companies.
SEE BOX

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