Merger analysis 40 - Nina's Fashion

Table of Contents

1. Questions

2. Appendix
2.1 Appendix A: Cash flow statement – PV
2.2 Appendix B: CAPM (Q4)
2.3 Appendix C: Premium per share (Q7)
2.4 Appendix D: Sensitivity analysis growth rate (Q9)
2.4.1 Appendix D: Growth rate to maximum stock price
2.5 Appendix E: Sensitivity analysis – beta & market risk premium – tables (Q10)
2.6 Appendix F: Sensitivity analysis – beta & market risk premium – graphs (Q10)
2.7 Appendix G: Share price range

3. References

1. Questions

1) Companies with few investment opportunities can invest money in an acquisition to forego issues of taxes at a personal level or excessive FCF. In addition, but not as a sole purpose, large tax losses or carry forwards by the target company could be used to reduce the future tax liability of the combined company. However, different papers state that the premium paid by the acquirer often exceeds the tax savings and is therefore undesirable for the company and especially for the society, since the shareholder’s wealth is reduced. In addition, managers who acquire other companies for the sole purpose of diversification destroy value and engage most of the time in self-entrenchment, because research showed that diversified firms are less valuable than if they were not diversified. Top management often has an incentive to engage in empire building because their salary partly depends on firm size. Therefore, a company should pay out earnings because investors have discretionary power over the use of those and can diversify in an asset class that fits their overall portfolio. All other uses would destroy value for the shareholders and society at large. Another reason for acquisitions is the purchase of assets from other companies below their replacement cost, because other entities than the owning company can still reap benefits from it since it is in operation and only requires maintenance. For example a company could purchase a factory, which is not state of the art, but in good shape and still operating. Again, as in the case of taxes, it would benefit a single market participant, but would be value destructing to society and would not contribute to an efficient economy, since most companies buy the asset with the intention to sell it at a profit rather than using it. But, most important and today’s main reason of acquisitions are synergies. Synergies are the reason why two companies combined are more valuable than the sum of its parts. After the acquisition the combined company might experience scale economies in its operations, has a better analyst coverage by stock market analysts and therefore, because of higher information efficiency, lower transaction and financing cost. These are probably the main reasons for Nina’s acquisition of the Chic Company. Increased market power will lead to benefits, but this is subject to rigorous investigation by governmental antitrust agencies, since monopolistic market power harms consumers and the society as a whole, as higher prices can be charged due to less competition. Finally, the assets of the target company might have a more productive use, because the management of the acquiring company uses those more efficiently. On the other hand, if the acquirer only purchases the assets because they are cheaper than replacement costs, but not useful, it is questionable whether it adds value to the firm and to the society. Furthermore, operating and financial economies are socially desirable, because they increase efficiency while competition reducing mergers harm society.

2) In a friendly takeover the acquiring and target company’s management negotiate, determine a price and the acquiring company makes a tender offer to the shareholders, while the target management advises the shareholders to take the offer, since the acquirer quotes a fair price and has good intentions. Contrary, in a hostile takeover the acquirer makes a tender offer to the target shareholders without negotiating with the management. The target’s management advises their shareholders not to take the offer, because the price is too low or because they fear too loose their jobs. To counter such actions, a hostile bidder can make a “blowout” bid as their opening bid, thereby providing a substantial premium above the preannouncement price that current stockholders can hardly resist the temptation to tender their shares. However, according to Brigham and Daves (2007) most hostile bids fail (Brigham & Daves, 2007).

3) The free cash flow (FCF) consists of (appendix A). Normally, interest expense is accounted for in the WACC, but since the interest expense in a merger typically varies due to different debt levels at different stages, it is more accurate to include it in the cash flow statement. The APV accounts with the separate tax shield valuation for this issue. It is basically a simulation how the acquisition would change the cash flows of the acquiring company. The retentions have to be deducted since those are required to support the growth of the acquired assets. It is necessary for new investment or working capital needs associated with this growth, and has to be accounted for since we also include the growth in sales.

4) Since the combined company’s capital structure changes, we can either apply the adjusted present value (APV) method or the FCFE method. Furthermore, because no explicit dollar amounts and cost of debt are given, the FCFE method rules out. Since we use the APV method we need the unlevered cost of equity, since the value of the tax shield is, due to the same riskiness as the firms operations, discounted at the unlevered cost of equity. If you use Hamada’s equation to calculate the unlevered beta , one has to use the old debt level and 30% tax rate, since the levered beta is calculated based on the old capital structure. Further, one can plug into the CAPM model to arrive at 14.901% unlevered cost of equity (appendix B). The levered cost of equity of 17.85% can be found out by re-levering the unlevered beta. With the new debt and tax level ( ) and plugging it into the CAPM model. However we will base our further analysis on the APV method taking the unlevered cost of equity. The proxy for is the T-bond rate, which was given with . The unlevered cost of equity and thereby the separate valuation of and is very suitable in circumstances of changing capital structures, because one can assume a changing cost of debt. Therefore we think our estimate is pretty reliable and the discount rate is more likely to be in error within a range of 1 - 3%, because it is still an estimate, which reacts to unpredictable changes in market risk premium, risk free rate or beta (appendix E & F).

5) The terminal value of Chic is 22,358,256$ for and 1,695,412$ for (appendix A), which generates a total of 24,053,669$ beyond 1996. The PV of the incremental cash flow calculation yields 18,457,307$. Another company would probably value the incremental cash flows differently, because they could make different use of synergies. Therefore the calculations would yield different cash flows and subsequently a different firm value, which might be either higher or lower. Further a different beta estimate, financing mix or tax rate would change the discount rate and the value (appendix E & F).

6A) There are several defenses, which Chic could use to keep the firm independently. Firstly, Chic could change the bylaws so that the approval of a merger has to be supported by a majority of 75% and make use of a staggered board. Secondly, the target firm could convince the current shareholders that the offered price is too low. Thirdly, they could raise antitrust issues, which might result in an intervention of the Justice Department. In addition, Chic could also repurchase shares in the hope of an increase in stock price above the one offered by the acquirer. Furthermore finding a white knight or white squire could also be used as defense strategy. Finally, there are several kinds of poison pills, Chic could use such as borrowing short-term loans, which have to be repaid immediately in case of a takeover, selling of company’s crown jewels, giving away lucrative golden parachutes for managers and purchasing questionable assets with a huge amount of debt. One other poison pill, which has become most popular in recent years, concerns the stock purchase rights for stockholders. In this defense strategy, stockholders can purchase stock at half the price of the acquiring firm when it is actually taken over.

6B) Chic’s manager should look for a so-called white knight, since a white knight is acceptable for Chic as a takeover candidate and would therefore compete with the potential acquirer. Furthermore a white knight is in most cases cheaper than poison pills, which destruct value. Hence, this might drive up the stock price due to the increased competition. Furthermore, Chic could engage in different kinds of divestitures. For instance, in a spin-off, the stockholders will receive ownership in the divested business. Researchers have found out that the market reacts positively to the divesting company on the day of the announcement which increases the stock price and hence, the value of the stockholders.

6C) In friendly mergers as well as hostile takeover, investment banks should be included, since both parties can gain an advantage from that. The acquiring firm wants to know the lowest price, which they have to pay for the target firm whereas the latter one may want to seek help in pointing out that the price, which is offered, is indeed too low.

6D) Indeed, there are potential conflicts of interest. If the acquirer is successful in the takeover, the managers of the acquired firm often lose their jobs and erode their status whereas shareholder of the acquired firm gain substantial value, since empirical evidence has shown that the stock price of the takeover candidate increases when the acquisition is executed. Hence, the managers are motivated to reward themselves and the staff. For instance, the managers might purchase perks and perquisites just before the takeover or they could establish employee stock ownership plans (ESOP), which will cause costs and hence, decrease the value to the acquirer.

7) Based on the calculations in Appendix C, Nina’s could pay a premium of 0,346$ per share (23% premium), due to projected synergy effects. Since empirical evidence shows that the target company’s shareholders gain the value, Nina’s should make a “blowout” bid of 0,30$ per share to preempt counteractions (Q6) of management and to deter other bidders. Moreover a bid close to 1,50$ would benefit Nina’s shareholders, whereas a price of 1,846$ would benefit Chic’s shareholders (appendix G). Empirical evidence shows that, both companies include investment banks to determine the fair value of the object subject to negotiations. Consequently, a very low initial offer price would appear to be a bad deal for Chic’s shareholders, hence management would not advise the deal and it could turn hostile. According to Brigham and Dawes (2007) hostile takeover bids often fail.

8) On average, researchers found out that the stock price of the acquired firm increases by roughly 30% in a hostile tender offer. In a friendly takeover, it is examined that the stock price rises by 20%. However, the acquirer’s stock price remained constant in either case. As a consequence, it can be pointed out that on average, merger creates value, but the target firm’s shareholders absorb the entire benefits. This would mean that in our case the acquisition price per share is close to 1,84$ as shown in the figure in appendix G. Consequently, the acquiring firm’s shareholders should be dubious when the management thinks about an acquisition. Especially taking into account that managers are keen to increase the firm size, since firm size is usually positively correlated to salaries plus job security, perquisites, power and prestige.

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