FIN2101 BUSINESS FINANCE II
Module 5 - Takeovers
Student Activities
Reading
Text,Chapter 19
Text Study Guide,Chapter 19
Study Book,Module 5
Selected Reading 5.1
Tutorial Activities
Tutorial Workbook,Self Assessment
Activity 5.1
Text Study Guide,Chapter 19,All
Terminology
A TAKEOVER occurs when a company
acquires a controlling interest in another
company.
A MERGER usually involves two or more
independent companies coming together
by mutual agreement.
A CONSOLIDATION is the combination of
two or more firms to form a completely
new company.
More Terminology
Acquiring company vs target company
Hostile vs friendly takeover
Strategic vs financial merger
Types of Takeovers
Horizontal
– 2 companies in same line of business.
Vertical
– a takeover of either the supplier of goods/raw
materials to,or a consumer of goods produced by,
the acquiring company.
Congeneric
– in the same general industry but neither in the
same line of business nor a supplier or customer.
Conglomerate
– in an unrelated business or industry.
Reasons for Takeovers
Like any other investment – maximise the
value of the acquiring company’s shares.
Must be financial benefits.
Motivated by a desire for greater returns or
reduction in risk profile,or both.
Reasons for Takeovers
Target company is managed inefficiently
Complimentary assets
Target company is undervalued
Reasons for Takeovers
Cost reductions
Increased market power
Excess liquidity & free cash flow
Reasons for Takeovers
Tax benefits
–continuity-of-ownership test
–continuity-of-business test
Text (pp,702-6) and Study Book
(pp,5.2-5.4)
Invalid/Dubious Reasons
Diversification
– Risk reduction
Increased debt capacity
– the co-insurance effect
Higher EPS
– bootstrapping
The Co-insurance Effect
Combining two companies whose
earnings streams are less than perfectly
positively correlated will lower the risk of
default on debt,so that the debt capacity
of the combination is greater than the sum
of the debt capacities of the two
companies operating separately.
Bootstrapping
Occurs in share-exchange takeovers
whenever the acquiring company’s P/E
ratio is greater than the target
company’s P/E ratio.
Need to distinguish between the effects
of true growth and the bootstrap effect.
Study Book Example 5.1.
Reasons for Takeovers
Valid Reason:
I.E,SYNERGISTIC EFFECT
BABA PV PV PV
Synergism
The combined company must be of
greater value than the sum of the
parts:
2 + 2 = 5 Benefit
2 + 2 = 4 No Benefit
Terms of Offer
Cash (when shares are purchased on
the stock market).
Exchange of shares and/or cash (in
the case of a formal offer).
Share Swap Transactions
Ratio of exchange is the ratio of the
amount paid per share of the target
company to the market price per share of
the acquiring company.
Assume that the acquirer’s share price is
$80 and the target’s shares have a market
price of $75,If the acquirer offers $110
per share for the target,the ratio of
exchange is 1.375 ($110? $80).
Share Swap Transactions
The ratio of exchange is used in assessing
the effects of a proposed takeover on
EPS,both in the short-term and the long
run.
The ratio is also used in evaluating the
effect of a takeover on the market price of
the acquiring company’s shares.
Read the text (pp,710-715) and work
through the various examples.
Financial Evaluation of
Takeovers
A capital budgeting decision
NPV technique
Incremental cash flows
NPV = Gain - Net Cost
Where:
Gain = PVA+B - (PVA + PVB)
(ie PV of incremental cash flows)
Net Cost = Price Paid - PVB
Example 1
SQUARE can purchase CIRCLE for $60 000.
SQUARE’S post-takeover cost of capital will be 10%.
Post-takeover cash flows attributable to the target
company CIRCLE are:
Years 1-10 $ 5 000 p.a.
Years 11-18 $13 000 p.a.
Years 19-30 $ 4 000 p.a.
Should SQUARE purchase CIRCLE?
Example 1 Solution
NPV > 0,SQUARE should purchase CIRCLE.
402 $2
000 $60 - 906 $4 771 $26 725 $30
000 $60 - 0.180 6.814 000 $4
0.386 5.335 000 $13 6.145 000 $5
000 $60 - P V I F P V I F A 000 $4
P V I F P V I F A 000 $13 P V I F A 000 $5 N P V
0,1 0,1 80,1 0,1 2
0,1 0,1 00,1 0,80,1 0,1 0
Example 2
A is thinking about acquiring B,A has
10m shares issued at a current market
price of $2,B has 1m shares issued at a
current price of $5,A’s managers think
they can buy B for $8m ($8 per share) and
they also estimate that the combined
company will be worth $30m.
What is the NPV of the takeover to A’s
shareholders?
Example 2 Solution
$3m
$5m - $8m
PV - pa i d P r i c e c os t N e t
$5m
$5m $20m - $30m
PV PV - PV G a i n
c os tN e t -G a i n N P V
B
BAAB
Example 2 Solution
$2m
$3m - $5m N P V
Example 2 Extended
What is the maximum price that A should
pay for B?
Equal to the present value of B to A:
$10m
$5m $5m
PV G a in PV
BAB
Determination of the Gain
It is not always as easy to calculate the gain
from a proposed takeover.
The gain is equal to the present value of the
incremental cash flows that will result from the
takeover:
– Inflows,Increased sales revenue,cost savings,sale
of assets.
– Outflows,Operating costs,capital outlays for new
assets or upgrade of existing assets.
Example 5.3 in Study Book.
Example 3
LMN Ltd has 5 million shares issued at a
current market price of $1.75 per share.
XYZ Ltd has 3 million shares issued at a
current market price of $1.10 per share.
LMN Ltd is considering acquiring XYZ Ltd
and has assembled the following data.
Example 3
1,LMN will need to inject a total of $1.25 million
into upgrading and/or replacing plant and
equipment.
2,This upgrade/replacement,along with improved
efficiencies,will increase annual operating
cash flows by an estimated $400 000 in
perpetuity.
3,LMN will sell off some of XYZ’s older assets
and expects to generate proceeds of $500 000
from the sale,However operating cash flows
will,as a consequence,be reduced by $50 000
per annum in perpetuity.
Example 3
Assuming a required rate of return of 10%
per annum,calculate:
– The gain from the takeover.
– The maximum price per share that LMN Ltd
should be prepared to pay for XYZ Ltd’s
shares.
Example 3 Solution
The change in annual net operating cash
flows is calculated as follows:
The PV of the annual net operating cash
flows is:
000 $350
000 $50 - 000 $400
0 0 0 5 0 0 $3
0,1 0
0 0 0 $ 3 5 0 PV
Example 3 Solution
000 300 $3
$1,10 m i l l i on 3 PV
000 750 $2
000 $5 00 000 250 $1 - 000 500 $3 G a i n
X Y Z
Example 3 Solution
$2.02
000 000 3
000 050 $6
s h a r epe r pr i c e M a x,
000 050 $6
000 300 $3 000 750 $2
PV G a i n PV
X Y ZL M NX Y Z
Example 3 Extended
Assume now that LMN Ltd agrees to pay
$1.65 for each share in XYZ Ltd.
Calculate the net cost of the takeover and
the NPV.
Example 3 Solution
000 650 $1
000 300 $3 - 000 950 $4
000 300 $3 - $1,65 000 000 3
PV - pa i d P r i c e c os t N e t
X Y Z
Example 3 Solution
0 0 0 1 0 0 $1
0 0 0 6 5 0 $1 - 0 0 0 7 5 0 $2
c o s tN e t -G a i n N PV
L M N
Determining Net Cost
Simple in a cash offer (see also Example
5.4 in Study Book).
Speculation/rumour about a takeover may
already be reflected in the market price of
shares of the target company.
The true value of the target to the
acquiring company should be used in
calculating the net cost of the takeover
(see also Example 5.5 in Study Book).
Example 3 Extended
Assume now that speculation about a
takeover has increased XYZ Ltd’s share
price from $0.95 to its current level of
$1.10.
What is the maximum price that LMN
should pay for XYZ?
What is the net cost and the NPV of the
takeover?
Example 3 Solution
000 600 $5
000 850 $2 000 750 $2
$0,95 000 000 3 000 750 $2
PV G a i n PV
X Y ZL M NX Y Z
Example 3 Solution
000 100 $2
000 850 $2 - 000 950 $4
000 850 $2 - $1,65 000 000 3
PV - pa i d P r i c e c os t N e t
X Y Z
Example 3 Solution
0 0 0 $ 6 5 0
0 0 0 1 0 0 $2 - 0 0 0 7 5 0 $2
c o s tN e t -G a i n N PV
L M N
Determining Net Cost
Calculation of the net cost of a takeover
involving a share exchange is a little more
difficult (also Example 5.6 in Study Book).
where x is the fraction of the combined
company that will be owned by the former
shareholders of the target.
BAB PV - PV c o s t N e t x?
Example 3 Extended
Assume now that LMN Ltd offers 3 of its
shares for every 4 shares in XYZ Ltd.
Calculate the net cost and NPV of the
proposed takeover.
Example 3 Solution
After the takeover,shareholders in XYZ Ltd will
become shareholders in the post-takeover
entity.
LMN Ltd must issue another 2 250 000 shares to
XYZ Ltd’s shareholders,meaning that after the
takeover,there will be a total of 7 250 000
shares issued.
To calculate the net cost of the takeover,it is
first necessary to calculate the value of the post-
takeover firm.
Example 3 Solution
000 350 $14
000 750 $2 000 850 $2 000 750 $8
G a i n PV PV PV X Y ZL M NX Y ZL M N
Example 3 Solution
448 603 $1
000 850 2 $ - 448 453 $4
000 850 $2 - 000 350 $14
000 250 7
000 250 2
PV - x PVc o s t N e t
X Y ZX Y ZL M N
Example 3 Solution
5 5 2 1 4 6 $1
4 4 8 6 0 3 $1 - 0 0 0 7 5 0 $2
c o s tN e t -G a i n N PV L M N
Regulation of Takeovers
Commonwealth and State legislation.
Chapter 6 of the Corporations Law.
ASIC responsible for administration of
the legislation.
Trade Practices Act and Foreign
Takeovers Act also relevant.
Text,pp,715-7.
Takeovers Process
An investor may hold up to 20% of a
company’s shares at any one time.
Acquisition of shares beyond the 20% limit
is regulated:
– creeping takeover;
– formal takeover bid;
– on-market offer;
– scheme of arrangement.
Takeover Defences
Poison pill
– Issue securities that have attached to them certain
rights (eg special voting rights) that become effective
when a takeover is attempted.
– Target becomes less desirable to the acquirer.
– Not allowed in Australia.
Shark repellents
– Anti-takeover amendments to a company’s
memorandum of association that constrain the firm’s
ability to transfer managerial control of the firm.
– Not welcomed by shareholders of the target firm.
Takeover Defences
Greenmail
– The target repurchases through private
negotiation a large block of shares at a
premium from one or more shareholders to
block a hostile takeover.
White knight
– The target finds a friendly acquirer more to its
liking.
Takeover Defences
Golden parachutes
– Provisions in the contracts of key executives
that provide them with sizeable compensation
if the firm is taken over.
– Sometimes render the target undesirable.
Leveraged recapitalisation
– Involves the payment of a large debt-financed
cash dividend.
– Increases the firm’s leverage and deters the
takeover attempt.
Research on Takeovers
Financial statement-based studies
– Examine whether the ‘profitability’ of the
combined firm is greater than the ‘profitability’
of the two firms prior to the takeover.
Studies using market price data
– Attempt to measure abnormal price changes
in the shares of the firms around the time that
the combination activity occurs.
Research on Takeovers
A consistent finding across the different
studies is that shareholders in target
companies do well.
Evidence on returns to shareholders of
acquiring companies is less conclusive
but suggests that they receive little,if
any,benefits.
Corporate Restructuring
Leveraged buyouts (LBOs)
– The use of a large amount of debt (typically 90% or
more of the purchase price) to purchase a firm.
Divestitures
– The sale of some of a firm’s assets (often in the form
of a whole subsidiary,branch or division).
Spin-offs
– An operating unit becomes an independent company
owned by shareholders of the parent company.
Module 5 - Takeovers
Student Activities
Reading
Text,Chapter 19
Text Study Guide,Chapter 19
Study Book,Module 5
Selected Reading 5.1
Tutorial Activities
Tutorial Workbook,Self Assessment
Activity 5.1
Text Study Guide,Chapter 19,All
Terminology
A TAKEOVER occurs when a company
acquires a controlling interest in another
company.
A MERGER usually involves two or more
independent companies coming together
by mutual agreement.
A CONSOLIDATION is the combination of
two or more firms to form a completely
new company.
More Terminology
Acquiring company vs target company
Hostile vs friendly takeover
Strategic vs financial merger
Types of Takeovers
Horizontal
– 2 companies in same line of business.
Vertical
– a takeover of either the supplier of goods/raw
materials to,or a consumer of goods produced by,
the acquiring company.
Congeneric
– in the same general industry but neither in the
same line of business nor a supplier or customer.
Conglomerate
– in an unrelated business or industry.
Reasons for Takeovers
Like any other investment – maximise the
value of the acquiring company’s shares.
Must be financial benefits.
Motivated by a desire for greater returns or
reduction in risk profile,or both.
Reasons for Takeovers
Target company is managed inefficiently
Complimentary assets
Target company is undervalued
Reasons for Takeovers
Cost reductions
Increased market power
Excess liquidity & free cash flow
Reasons for Takeovers
Tax benefits
–continuity-of-ownership test
–continuity-of-business test
Text (pp,702-6) and Study Book
(pp,5.2-5.4)
Invalid/Dubious Reasons
Diversification
– Risk reduction
Increased debt capacity
– the co-insurance effect
Higher EPS
– bootstrapping
The Co-insurance Effect
Combining two companies whose
earnings streams are less than perfectly
positively correlated will lower the risk of
default on debt,so that the debt capacity
of the combination is greater than the sum
of the debt capacities of the two
companies operating separately.
Bootstrapping
Occurs in share-exchange takeovers
whenever the acquiring company’s P/E
ratio is greater than the target
company’s P/E ratio.
Need to distinguish between the effects
of true growth and the bootstrap effect.
Study Book Example 5.1.
Reasons for Takeovers
Valid Reason:
I.E,SYNERGISTIC EFFECT
BABA PV PV PV
Synergism
The combined company must be of
greater value than the sum of the
parts:
2 + 2 = 5 Benefit
2 + 2 = 4 No Benefit
Terms of Offer
Cash (when shares are purchased on
the stock market).
Exchange of shares and/or cash (in
the case of a formal offer).
Share Swap Transactions
Ratio of exchange is the ratio of the
amount paid per share of the target
company to the market price per share of
the acquiring company.
Assume that the acquirer’s share price is
$80 and the target’s shares have a market
price of $75,If the acquirer offers $110
per share for the target,the ratio of
exchange is 1.375 ($110? $80).
Share Swap Transactions
The ratio of exchange is used in assessing
the effects of a proposed takeover on
EPS,both in the short-term and the long
run.
The ratio is also used in evaluating the
effect of a takeover on the market price of
the acquiring company’s shares.
Read the text (pp,710-715) and work
through the various examples.
Financial Evaluation of
Takeovers
A capital budgeting decision
NPV technique
Incremental cash flows
NPV = Gain - Net Cost
Where:
Gain = PVA+B - (PVA + PVB)
(ie PV of incremental cash flows)
Net Cost = Price Paid - PVB
Example 1
SQUARE can purchase CIRCLE for $60 000.
SQUARE’S post-takeover cost of capital will be 10%.
Post-takeover cash flows attributable to the target
company CIRCLE are:
Years 1-10 $ 5 000 p.a.
Years 11-18 $13 000 p.a.
Years 19-30 $ 4 000 p.a.
Should SQUARE purchase CIRCLE?
Example 1 Solution
NPV > 0,SQUARE should purchase CIRCLE.
402 $2
000 $60 - 906 $4 771 $26 725 $30
000 $60 - 0.180 6.814 000 $4
0.386 5.335 000 $13 6.145 000 $5
000 $60 - P V I F P V I F A 000 $4
P V I F P V I F A 000 $13 P V I F A 000 $5 N P V
0,1 0,1 80,1 0,1 2
0,1 0,1 00,1 0,80,1 0,1 0
Example 2
A is thinking about acquiring B,A has
10m shares issued at a current market
price of $2,B has 1m shares issued at a
current price of $5,A’s managers think
they can buy B for $8m ($8 per share) and
they also estimate that the combined
company will be worth $30m.
What is the NPV of the takeover to A’s
shareholders?
Example 2 Solution
$3m
$5m - $8m
PV - pa i d P r i c e c os t N e t
$5m
$5m $20m - $30m
PV PV - PV G a i n
c os tN e t -G a i n N P V
B
BAAB
Example 2 Solution
$2m
$3m - $5m N P V
Example 2 Extended
What is the maximum price that A should
pay for B?
Equal to the present value of B to A:
$10m
$5m $5m
PV G a in PV
BAB
Determination of the Gain
It is not always as easy to calculate the gain
from a proposed takeover.
The gain is equal to the present value of the
incremental cash flows that will result from the
takeover:
– Inflows,Increased sales revenue,cost savings,sale
of assets.
– Outflows,Operating costs,capital outlays for new
assets or upgrade of existing assets.
Example 5.3 in Study Book.
Example 3
LMN Ltd has 5 million shares issued at a
current market price of $1.75 per share.
XYZ Ltd has 3 million shares issued at a
current market price of $1.10 per share.
LMN Ltd is considering acquiring XYZ Ltd
and has assembled the following data.
Example 3
1,LMN will need to inject a total of $1.25 million
into upgrading and/or replacing plant and
equipment.
2,This upgrade/replacement,along with improved
efficiencies,will increase annual operating
cash flows by an estimated $400 000 in
perpetuity.
3,LMN will sell off some of XYZ’s older assets
and expects to generate proceeds of $500 000
from the sale,However operating cash flows
will,as a consequence,be reduced by $50 000
per annum in perpetuity.
Example 3
Assuming a required rate of return of 10%
per annum,calculate:
– The gain from the takeover.
– The maximum price per share that LMN Ltd
should be prepared to pay for XYZ Ltd’s
shares.
Example 3 Solution
The change in annual net operating cash
flows is calculated as follows:
The PV of the annual net operating cash
flows is:
000 $350
000 $50 - 000 $400
0 0 0 5 0 0 $3
0,1 0
0 0 0 $ 3 5 0 PV
Example 3 Solution
000 300 $3
$1,10 m i l l i on 3 PV
000 750 $2
000 $5 00 000 250 $1 - 000 500 $3 G a i n
X Y Z
Example 3 Solution
$2.02
000 000 3
000 050 $6
s h a r epe r pr i c e M a x,
000 050 $6
000 300 $3 000 750 $2
PV G a i n PV
X Y ZL M NX Y Z
Example 3 Extended
Assume now that LMN Ltd agrees to pay
$1.65 for each share in XYZ Ltd.
Calculate the net cost of the takeover and
the NPV.
Example 3 Solution
000 650 $1
000 300 $3 - 000 950 $4
000 300 $3 - $1,65 000 000 3
PV - pa i d P r i c e c os t N e t
X Y Z
Example 3 Solution
0 0 0 1 0 0 $1
0 0 0 6 5 0 $1 - 0 0 0 7 5 0 $2
c o s tN e t -G a i n N PV
L M N
Determining Net Cost
Simple in a cash offer (see also Example
5.4 in Study Book).
Speculation/rumour about a takeover may
already be reflected in the market price of
shares of the target company.
The true value of the target to the
acquiring company should be used in
calculating the net cost of the takeover
(see also Example 5.5 in Study Book).
Example 3 Extended
Assume now that speculation about a
takeover has increased XYZ Ltd’s share
price from $0.95 to its current level of
$1.10.
What is the maximum price that LMN
should pay for XYZ?
What is the net cost and the NPV of the
takeover?
Example 3 Solution
000 600 $5
000 850 $2 000 750 $2
$0,95 000 000 3 000 750 $2
PV G a i n PV
X Y ZL M NX Y Z
Example 3 Solution
000 100 $2
000 850 $2 - 000 950 $4
000 850 $2 - $1,65 000 000 3
PV - pa i d P r i c e c os t N e t
X Y Z
Example 3 Solution
0 0 0 $ 6 5 0
0 0 0 1 0 0 $2 - 0 0 0 7 5 0 $2
c o s tN e t -G a i n N PV
L M N
Determining Net Cost
Calculation of the net cost of a takeover
involving a share exchange is a little more
difficult (also Example 5.6 in Study Book).
where x is the fraction of the combined
company that will be owned by the former
shareholders of the target.
BAB PV - PV c o s t N e t x?
Example 3 Extended
Assume now that LMN Ltd offers 3 of its
shares for every 4 shares in XYZ Ltd.
Calculate the net cost and NPV of the
proposed takeover.
Example 3 Solution
After the takeover,shareholders in XYZ Ltd will
become shareholders in the post-takeover
entity.
LMN Ltd must issue another 2 250 000 shares to
XYZ Ltd’s shareholders,meaning that after the
takeover,there will be a total of 7 250 000
shares issued.
To calculate the net cost of the takeover,it is
first necessary to calculate the value of the post-
takeover firm.
Example 3 Solution
000 350 $14
000 750 $2 000 850 $2 000 750 $8
G a i n PV PV PV X Y ZL M NX Y ZL M N
Example 3 Solution
448 603 $1
000 850 2 $ - 448 453 $4
000 850 $2 - 000 350 $14
000 250 7
000 250 2
PV - x PVc o s t N e t
X Y ZX Y ZL M N
Example 3 Solution
5 5 2 1 4 6 $1
4 4 8 6 0 3 $1 - 0 0 0 7 5 0 $2
c o s tN e t -G a i n N PV L M N
Regulation of Takeovers
Commonwealth and State legislation.
Chapter 6 of the Corporations Law.
ASIC responsible for administration of
the legislation.
Trade Practices Act and Foreign
Takeovers Act also relevant.
Text,pp,715-7.
Takeovers Process
An investor may hold up to 20% of a
company’s shares at any one time.
Acquisition of shares beyond the 20% limit
is regulated:
– creeping takeover;
– formal takeover bid;
– on-market offer;
– scheme of arrangement.
Takeover Defences
Poison pill
– Issue securities that have attached to them certain
rights (eg special voting rights) that become effective
when a takeover is attempted.
– Target becomes less desirable to the acquirer.
– Not allowed in Australia.
Shark repellents
– Anti-takeover amendments to a company’s
memorandum of association that constrain the firm’s
ability to transfer managerial control of the firm.
– Not welcomed by shareholders of the target firm.
Takeover Defences
Greenmail
– The target repurchases through private
negotiation a large block of shares at a
premium from one or more shareholders to
block a hostile takeover.
White knight
– The target finds a friendly acquirer more to its
liking.
Takeover Defences
Golden parachutes
– Provisions in the contracts of key executives
that provide them with sizeable compensation
if the firm is taken over.
– Sometimes render the target undesirable.
Leveraged recapitalisation
– Involves the payment of a large debt-financed
cash dividend.
– Increases the firm’s leverage and deters the
takeover attempt.
Research on Takeovers
Financial statement-based studies
– Examine whether the ‘profitability’ of the
combined firm is greater than the ‘profitability’
of the two firms prior to the takeover.
Studies using market price data
– Attempt to measure abnormal price changes
in the shares of the firms around the time that
the combination activity occurs.
Research on Takeovers
A consistent finding across the different
studies is that shareholders in target
companies do well.
Evidence on returns to shareholders of
acquiring companies is less conclusive
but suggests that they receive little,if
any,benefits.
Corporate Restructuring
Leveraged buyouts (LBOs)
– The use of a large amount of debt (typically 90% or
more of the purchase price) to purchase a firm.
Divestitures
– The sale of some of a firm’s assets (often in the form
of a whole subsidiary,branch or division).
Spin-offs
– An operating unit becomes an independent company
owned by shareholders of the parent company.
