External Growth through Mergers
(Part B)
by
Charles Lamson
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Terms of Exchange
In determining the price that will be paid for a potential acquisition, a number of factors are considered, including earnings, cash flow, dividends, and growth potential. We shall divide our analysis between cash purchases and stock-for-stock exchanges, in which the acquiring company trades stock rather than paying cash for the acquired firms. Cash Purchases The cash purchase of another company can be viewed within the context of a capital budgeting decision. Instead of purchasing new plant or machinery, the purchaser has opted to acquire a going concern. For example, assume the Invest Corporation is analyzing the acquisition of the Sell Corporation for $1 million. The Sell Corporation has expected cash flow (after-tax earnings plus depreciation) of $100,000 per year for the next five years and $150,000 per year for the 6th through the 20th years. Furthermore, the synergistic benefits of the merger (in this case, combining production facilities) will add $10,000 per year to cash flow. Finally, the Sell Corporation has a $50,000 tax loss carryforward (provision that allows a taxpayer to carry over a tax loss to future years to offset a profit) that can be used immediately by the Invest Corporation. Assuming a 40 percent tax rate, the $50,000 loss carryforward will shield $20,000 of profit from taxes immediately. The Invest Corporation has a 10 percent cost of capital, and this is assumed to remain stable with the merger. Our analysis would be as follows:  The present value factor for the first 5 years (3.791) is based on n = 5, i = 10 percent, and can be found in Table 1 used throughout this analysis and reintroduced below. For the 6th through the 20th years, we take the present value factor in Table 1 n = 20, i equals 10 percent, and subtract the present value for n = 5, i = 10 percent. This allows us to isolate the 6th through the 20th years with a factor of 4.723 (8.514 - 3.791 close).  Finally the net present value of the investment is:  The acquisition appears to represent a desirable alternative for the expenditure of cash, with a positive net present value of $192,690.  In the market environment of the last four decades, some firms could be purchased at a value below the replacement costs of their assets and this represented a potentially desirable capital investment. As an extreme example, Anaconda Copper had an asset replacement value of $1.3 billion when the firm was purchased by Atlantic Richfield for $684 million in the 1980s. With the stock market gains of the 1990s such bargain purchases were more difficult to achieve (Block & Hirt, p. 590). Stock-for-Stock Exchange On a stock-for-stock exchange, we use a somewhat different analytical approach, emphasizing the earnings per share impact of exchanging securities (and ultimately the market valuation of those earnings). The analysis is made primarily from the viewpoint of the acquiring firm. The shareholders of the acquired firm are concerned mainly about the initial price they are paid for their shares and about the outlook for acquiring firm. Assume that Expand Corporation is considering the acquisition of Small Corporation. Significant financial information on the firms before the merger is provided in Table 2. Table 2 Financial data on potential merging firms  We begin our analysis with the assumption that one share of Expand Corporation ($30) will be traded for one share of Small Corporation ($30). In actuality, Small Corporation will probably demand more than $30 per share because the acquired firm usually gets a premium over the current market value. We will later consider the impact of paying such a premium.  If 50,000 new shares of Expand Corporation are traded in exchange for all the old shares of Small Corporation, Expand Corporation will then have 250,000 shares outstanding. At the same time, its claim to earnings will go to $700,000 when the two firms are combined. Post-merger earnings per share will be $2.80 for the Expand Corporation, as indicated in Table 3. Table 3 Postmerger earning per share  A number of observations are worthy of note. First the earnings per share of Expand Corporation have increased as a result of the merger, rising from $2.50 to $2.80. This has occurred because Expand Corporation's P/E ratio of 12 was higher than the 7.5 P/E ratio of Small Corporation at the time of the merger (as previously presented in Table 2). Whenever a firm acquires another entity whose P/E ratio is lower than its own, there is an immediate increase in earnings per share. Of course, if Expand Corporation pays a price higher than Small Corporation's current market value, which is typically the case, it may be paying equal to or more than its own current P/E ratio for Small Corporation. For example, at a price of $48 per share for Small Corporation, Expand Corporation will be paying 12 times small corporations earnings, which is exactly the current P/E ratio of Expand Corporation. Under these circumstances there will be no change in post-merger earnings per share for Expand Corporation. Endless possibilities can occur in mergers based on stock for stock exchanges. Even if the acquiring company increases its immediate earnings per share as a result of the merger, it may slow its future growth rate if it is buying a less aggressive company. Conversely, the acquiring company may dilute immediate postmerger earnings per share but increase its potential growth rate for the future as a result of acquiring a rapidly growing company. The ultimate test of a merger rests with its ability to maximize the market value of the acquiring firm. This is sometimes a difficult goal to achieve but is the measure of the success of a merger.  Portfolio Effect Inherent in all of our discussion is the importance of the merger's portfolio effect on the risk-return posture of the firm. The reduction or increase in risk may influence the P/E ratio as much as the change in the growth rate. To the extent that we are diminishing the overall risk of the firm in a merger, the post-merger P/E and market value may increase even if the potential earnings growth is unchanged. The business risk reduction may be achieved through acquiring another firm that is influenced by a set of factors in the business cycle opposite from those that influence the firm, while financial risk reduction may be achieved by restructuring the post merger financial arrangements to include IRS debt. Perhaps Expand Corporation may be diversifying from a heavy manufacturing industry into the real estate/housing Industry. While heavy manufacturing industries move with the business cycle., the real estate/housing Industry tends to be countercyclical. Even though the expected value of earnings per share may remain relatively constant as a result of the merger, the standard deviation of possible outcomes may decline as a result of risk reduction through diversification. And if there is less risk in the corporation, the investor may be willing to assign a higher valuation, thus increasing the price earnings ratio.  *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 589-592* end |
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