Finance Case Writing

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timer Asked: Apr 16th, 2017

Question description

Hi

I need people to write a case for my finance class, instructor requested that we needed to have a presentation about 10 minutes with a visual aid, along with a case submitted.

Please write a case no less than 10 pages, not including title page, reference page and abstract. There are 12 questions at the end of the case, make sure to consider the answer of the questions (do not directly quote the question, but talk About the answer while writing), and analysis of this case.

Beside this, we still need a PPT as visual aid in the presentation, the PPT is about 10 pages. No similar work accepted, IT MUST BE A UNIQUE WORK FROM YOU. thanks.

12 Case 70 Computer Concepts/Computech Mergers Directed In recent years, it has become fairly common for computer hardware and software companies to mergewith one another in an effort to gain economies of scale and scope and thus be better able to competewith larger rivals in the marketplace. The mergers are generally either horizontal (for example, when two software companies merge to expand their product lines) or vertical (for example, when a hardware company acquires a software company to obtain software to package with its computers.) CompuTech Industries was recently bitten by the merger bug. The company was founded by MarcoGaribaldi in the basement of his parents' home in 1983. Garibaldi had no intentions of competingwith the "giants" in the industry (Microsoft, Lotus, etc.), but rather finding a market niche of hisown. Garibaldi envisioned selling software to individuals at a low economical price and grabbing the low-priceend of the market. Garibaldi was a mathematical wizz and "computer hacker" who had dropped out of college becausehe was not intellectually challenged. The idea for CompuTech actually originated from one of Marco's other hobbies—writing science fiction novels. Although Marco enjoyed concocting his sci-fi stories, he hated spending endless hours retyping manuscripts to correct his typographical errors.He surmised that college students probably disliked this chore at least as much as he did, so he set out to develop a user-friendly word processing computer program aimed at high school and college level students. He called the computer software program WordPro Easy, and it was an overnightsuccess. In fact, the program received wide acceptance from both the academic and the business communities. Marco had not foreseen how quickly CompuTech would grow and the amountOfcapital that would be necessary to fund its growth. However, he received numerous offers from venturecapital funds, and this supported early growth. Marco's goal was to take the firm public, which he did in 1990. By December 31, 1995, CompuTech's stock was selling for $25 per share, and there were 10 million shares outstanding. During the company's 12 years of existence, CompuTech developed a solid reputation for ingenuity,reliability, and timely introduction of new products. In addition, unlike many of its rivals,CompuTech maintains a toll-free telephone technical support service for users, and it uses informationfrom the service both to identify and correct potential program bugs and to get ideas for product improvements. Consequently, WordPro Easy has been updated frequently, enabling it to maintainits strong market position. More recently, the firm's programmers created a presentation @ 1997 South-Western, a part of Cengage Leaming 87 o o o o o o like WordPro acceptance because, market received wide package called Chart Easy that has also found spreadsheet market, it financial the due to to enter not caught on, partly However, when CompuTech attempted simply has sepleadsheetEasy, psreodaunct! perception that the firm's Ittso the going milh rtougheart the market's to due partly programs have an CompuTech's late entrance into the market, firms' spreadsheet other because Garibaldi expertise is not financial software, and partly spreadsheet market has financial the enter preestablished hold on the market. This failure to their word processing, bundling increasingly that if worried, because rival software companies are Garibaldi fears, correctly, suite." "office one sentation, and financial software programs into an office package, the software programs into its bundle and market the follow following. Garibaldi CompuTech were to have a strong market doesn't Easy Spreadsheet because package would fail a similar reputafindinga firm which enjoys in lies success continued with it believes that CompuTech's spreadsheet programs and brings financial in specializes that one but lion to CompuTech's, a strong market following. specializes Concepts Inc. (CCI), a firm that One potential acquisition candidate is Computer in the founded was Like CompuTech, CCI in accounting, finance, and tax return software programs. million (Three and went public in 1993. early 1980s,expanded with the help of venture capitalists, were actually sold to raise $2.5 milshares shares had been offered at $1.25 per share, and 2.5 million program, Model Pro, was an initial suclion, net of underwriting fees.) CCI's financial spreadsheet demands. Consequently, it has an cess and has been continually updated to meet changing market spreadsheet created by it could be excellent market following. Also, Model Pro was written so that a Easy). The firm's one incorporated as text into most word processing programs (including WordPro views a merger Garibaldi perceived weakness is its lack of diversity in software product offerings. to with CCI as a perfect fit with CompuTech—such a merger would provide a way for CompuTech enter the financial software market and thus solve his office suite problem. The primary issues now facing CompuTech are (l) how much to offer for CCI's stock and (2) how to approach CCI's management. Marco Garibaldi and his staff are good at developing computer software programs, but they are not finance experts and are not experienced with acquisitions. So, rather than taking a chance on making a mistake, they decided to bring your consulting firm in to advise them on the CCI merger. Table I provides some information on CCI. The stock is traded infrequently and in small blocks, and while the last trade was at a price of $1.50, it would probably run up sharply if a large buy order were placed. CCI's beta coefficient is 1.6, and that number is close to the average beta for publicly traded computer software companies. If the acquisition takes place, CompuTech would increase CCI's debt ratio from 10 to 25 percent, and consolidation of income for tax purposes would move CCI's 30 percent federal-plus-state tax rate up to that of CompuTech's, 40 percent. CCI's management owns about 30 percent of the stock, which is substantial but not enough to completely block a merger. They might fight to keep the firm independent if CompuTech makes an offer, but there is a chance that they would welcome a chance to sell out. They also might want to remain active, but would appreciate being acquired by a firm which would provide them with product diversity, something that it is currently lacking. To the best of Marco Garibaldüs knowledge, CCI's managers have had no discussions with anyone about a merger, and the few analysts who follow the stock have not said anything about the possibility of a takeover. However, Garibaldi is afraid some other software company might force a bidding war if CompuTech decides to make an offer. CCI does not appear to be large enough to interest companies like IBM or Microsoft, but such to decide might buy a company CCI for its accounting and tax applications and then cultivate them. Marco Garibaldi wants your opinion on how CompuTech should approach CCI's management. should he decide to make an offer. One possibility would be to go to its management with a relatively low offer which could later be increased if necessary. Another would be to come in with a high offer and attempt to preempt any outside challenge. A third plan would be to by-pass man- @ 1997 South-Western, a part of Cengage Learning 88 o agementaltogether and make a tender offer directly to CCI's stockholders. So, part of your task is these approaches, plus any others you might think of. todiscussthe pros and cons of past, built its software business "from the ground up" rather than compuTech has, in the throughacquisitions, and some of Garibaldi's managers prefer internal expansion to acquisitions. Therefore,Garibaldi wants you to include, in your report and presentation, a discussion of mergers versusbusiness creation to achieve CompuTech's strategic objectives. He also wants you to commenton whether there might be any legal impediments to a merger with CCI. A discussion of the prosand cons of a hostile versus a friendly merger would also be helpful. The proper price to offer is a critical issue. CCI's most recent stock price was $1.50 per share, andthereare 3,000,000 shares outstanding. That suggests that CCI's value is $4.5 million. However, analystsoften look at other data when appraising the value of stocks such as CCI for acquisition purposes,and they consider valuation multiples such as those shown in Table 1. The weights given to thedifferent multiples are somewhat arbitrary, and they vary from situation to situation. Also, someanalysts rely almost totally on a DCF calculation and use the multiples, if at all, simply as a checkto see if their DCF analysis is in the right ballpark. The multiples given in Table I are recent averagesfor software companies, but actual multiples for individual companies vary substantially dependingon the circumstances. Higher multiples are generally used for more rapidly growing firms, or for firmswith more growth potential, while lower multiples are used for highly leveraged firms. In addition,the stock prices of independent companies are frequently bid up over their going concernvalues once investors start thinking of them as acquisition candidates. Garibaldi does not thinksuch a "merger premium" is reflected in CCI's current stock price, but he is not sure about this. If no mergerpremium is currently embodied in the price, then CompuTech would probably have to offera premiumto get CCI's stockholders to agree to sell. So, Garibaldi wants to know the maximumpriceCompuTech could afford to pay without diluting its own value. He also wants to know theminimumprice CCI's stockholders are likely to accept. Then, if the price CompuTech can afford exceedsthe price CCI will accept, a merger is at least feasible. To find the maximum price CompuTech can pay, Garibaldi wants you to develop pro forma financialstatements and then use them to determine the cash flows CompuTech would realize if it buysCCI.The present value of those cash flows can then be used to estimate the maximum offer price.Of course, Garibaldi would like to buy CCI at a lower price, because the merger will not benefitCompuTech's current stockholders unless it can be completed at a price less than the PV of the cash flows. It may turn out that CCI's management would welcome a merger, in which case they may notbargaintoo hard. However, since the management team owns 30 percent of the stock, they will wantto get a high price, and that (plus a legal obligation to do so) might lead them to solicit competingbids. Also, you know that CCI's management team is relatively young and aggressive, so they probablywill not want to retire. Therefore, what they are offered in terms of employment, and their compensationpackage, will have an effect on their attitude toward a merger. Garibaldi wants you to addressthat issue. Table2 contains some pro forma financial data that Garibaldi's people worked up from the set OfdataCCIdisclosed as a part of its recent public offering. The data in Table 2 assume a takeover byCompuTech.The required addition to retained earnings represents the amounts that would be necessaryto finance the projected growth. Although specific estimates were only made for 1996 through1999,the acquired company would be expected to grow at a 5 percent rate in 2000 and beyond.However, actual growth could be greater or less than the expected growth rate, and this wouldsignificantly affect CCI's value. One important part of the merger analysis involves determining a discount rate to apply to theestimatedcash flows. In its merger work, your consulting firm uses a procedure developed by ProfessorRobert Hamada of the University of Chicago to adjust betas of financial to reflect differing degrees leverage. Hamada's basic equations are given below: @ 1997 South-Western, a part of Cengage Learning 89 9 3 o O o o b Formula to unlever beta: o O o o O Formula to relever beta: of the Here bUis the beta that CCI would have if it used no debt financing (the inherent beta assets), T is the applicable corporate tax rate, and D/S is the applicable market value debt-to-equity ratio. As shown in Table l, the T-bond rate is 6.5 percent, and your firmfs economists estimate that the market risk premium is currently 5 percent. Your task now is to complete a report in which you first address the issue of whether or not CompuTech should attempt to take over CCI. Based on your discussions with Garibaldi, you know that you should consider questions such as the following: If an attempt is to be made, how much should CompuTech offer, what is the maximum price it can afford to pay, and how would CCI's current management be likely to respond? Would CompuTech want CCI's current management team to stay on, or would CompuTech be better off if it replaced CCI's managers with its own people? Do the ratios provided in Table 2 look reasonable, or do they cast any doubts on the forecasts? Should CCI's stockholders be offered cash, debt securities, or stock in CompuTech? In addition to the projected cash flows, is there the potential for some "strategic option value" if CCI is acquired, and if so, how should this be factored in? Recognize that either Garibaldi or one of the other CompuTech managers could ask you follow-up questions, so you should thoroughly understand the implications of your analysis. To help structure your report, answer the following questions. QUESTIONS l. Several factors have been proposed as providing a rationale for mergers. Among the more prominent ones are (l) tax considerations, (2) diversification, (3) control, (4) purchase of assets below replacement cost, and (5) synergy. From the standpoint of society, which of these reasons are justifiable? Which are not? Why is such a question relevant to a company like CompuTech, which is considering a specific acquisition? Explain your answers. 2. Briefly describe the differences between a hostile merger and a friendly merger. Is there any reason to think that acquiring companies would, on average, pay a greater premium over target companies' pre-announcementprices in hostile mergers than in friendly mergers? 3. Complete CCI's cash flow statements for 1996through 1999. Why is interest expense typically deducted in merger cash flow statements, whereas it is not normally deducted in capital budgeting cash flow analysis? Why are retained earnings deducted to obtain the free cash flows? 4. Conceptually, what is the appropriatediscount rate to apply to the cash flows developed Question 3? What is the numerical value of the discount in rate? How much confidence one place in this estimate, i.e., is the estimated discount can rate likely to be in error by a small amount, such as I percentage point, or a large amount, such as 4 or 5 percentage Would an error in the discount rate have much of an points? effect on the maximum offer price? 5. What is the terminal value of CCI, that is, what is the 1999 value of the cash expected to generate beyond 1999? What is ccrs flows CCI is value to CompuTech at the beginning of 1996? Suppose another firm was evaluating CCI as a potential acquisition candidate. Would 0 1997South-Western, a part of Cengage Learning 90 has a substantial ownership interest in the company, but not enough 6. a. CCI's management If to block a merger. CCI's managers want to keep the firm independent, what are some actionsthey could take to discourage potential suitors? b. If CCI's managers conclude that they cannot remain independent, what are some actions they might take to help their stockholders (and themselves) get the maximum price for 9 their stock? c. IfCCI's managers conclude that the maximum price others are willing to bid for the companyis less than its "true value," is there any other action they might take that would benefitboth outside stockholders and the managers themselves? Explain. d. Do CCI's managers face any potential conflicts of interest (agency problems) in their negotiationswith CompuTech? If so, what might be done to reduce conflict of interest problems. 7. CCIhas 3 million shares of common stock outstanding. The shares are traded infrequently and in small blocks, but the last trade, of 500 shares, was at a price of $1.50 per share. Basedon this information, and on your answers to Questions 5 and 6, how much should CompuTechoffer for CCI, and how should it go about making the offer? 8. Doyou agree that synergistic effects probably create value in the average completed merger?If so, what determines how this value is shared between the stockholders of the acquiringand acquired companies? On average, would you expect more of the value to go to theacquiredor to the acquiring firm? Explain your answers. 9. A majorconcern when analyzing any merger is the accuracy of the cash flows. How would themaximumprice vary if the variable cost percentage were greater or less than the expected80 percent? If you are using the spreadsheet model, do a sensitivity analysis on the variablecost ratio, and also determine the maximum percentage that would justify a price of $3.50per share. If you do not have access to the spreadsheet model, simply discuss the issue,and explain why managers would be interested in such a sensitivity analysis. 10. Whatrate of return on equity is projected in the analysis? Should the projected ROE make you wantto question the assumptions that went into the cash flow and financial statement projections? ll. Wouldthe response of CCI's for stock in stockholders be affected by whether the offer was for cash or CompuTech? Explain. 12. Whatare your final conclusions? Should CompuTech make an offer, and if so, should they tryfor a friendly deal; what price per share should they offer; ment;and should how should they make paythey try to retain the present management? @ 1997 South-Western, a part of Cengage Learning 91 o O o o o TABLE 1 Selected Data Related to the o O 3 o o o o o o o Potential CCI Merger Data on 1995 Assets (end of year) 1995 Sales 1995 Net Income 425,000 1.6 Estimated beta coefficient 10.0% Debt ratio Tax rate Shares Outstanding Latest price per share 30.0% $1.50 CompuTech starting in 1996: Pro forma Data Assuming CCI is operated by 1996 Assets (end of year) 1996 Sales 1996 Net Income 808,650 25.0% 40.0% 20.0% 15.0% 5.0% Debt ratio Tax rate Sales growth, 1996—1999 Assets growth, 1996—1999 Long-run growth rate in sales and assets Other Data and Assumptions, Post-Merger: Risk-free rate Market risk premium Company's cost of debt Variable costs/sales Fixed costs/assets Depreciation/assets 6.5% 5.0% 10.0% 80.0% 20.0% 8.0% Valuation Multiples (averagesfor young, rapidly growing software firms): 10.0 Value as a multiple of cash flow 0.5 Value as a multiple of sales 12.0 Value as a multiple of net income 3.5 Value as a multiple of Market/Book The weights given to valuations based on these multiples are judgmental, not set by some formula. Note too that some people would give no weight whatsoever to valuations based on these multiples, relying instead only on DCF, i.e., giving 100 percent of the weight to the PV of cash flows. @ 1997 South-Western, a part of Cengage Learning 92 o TABLE 2 Pro Forma Data on CCI Assuming CompuTech's Management (end of year): BalanceSheet Information 1996 1997 1998 $ 4,562,625 Assets 1999 $ 5,247,019 862,500 Debt Incomeand Cash Flow Statements: 1996 o 1997 1998 8 1999 Net sales o Var. operating costs 276,000 690,000 86,250 Depreciation Fixedoperating costs Interestexpense Earningsbefore taxes 365,010 912,525 114,066 419,762 $ 2,064,399 $ 2,546,859 o 131,175 539,100 825,760 1,018,744 $808,650 276,000 365,010 419,762 Req'd addn to equity 388,125 513,295 196,763 Available CF Expectedterminal value 696,525 1998 7.17% 1999 7.37% 29.12% 38.83% 3.95 25.00% Taxes Net income Plus depreciation Cash flow Free cash flow $ 696,525 Maximumtotal offer, total: Maximumoffer price per share: Ratios: Returnon Sales Returnon Assets Returnon Equity Total Asset Turnover Debt/Assets o o 1996 6.74% 23.44% 1997 27.15% 36.20% 3.79 25.00% 31.25% 3.48 25.00% @ 1997 South-Western, a part of Cengage Leaming 93 o
Case 70 Computer Concepts/CompuTech Merger Analysis QUESTIONS Question 1 Several factors have been proposed as providing a rationale for mergers. Among the more prominent ones are (1) tax considerations, (2) diversification, (3) control, (4) purchase of assets below replacement cost, and (5) synergy. From the standpoint of society, which of these reasons are justifiable? Which are not? Why is such a question relevant to a company like CompuTech, which is considering a specific acquisition? Explain your answers. Answer: Synergy is by far the most socially justifiable reason for mergers. Synergy occurs when the value of the combined enterprise exceeds the sum of the values of the pre-merger firms. (If synergy exists, the whole is greater than the sum of the parts, hence, synergy is often described as "2 + 2 = 5.") A synergistic merger creates value, which must be allocated between the shareholders of the acquiring and the acquired firms. Synergy can arise from many sources, the most prominent being (1) operating economies of scale in management, production, marketing, or distribution; (2) financial economies, which could include higher debt capacity, lower transactions costs, or better coverage by securities' analysts which can lead to higher demand for the combined company's stock, and hence to higher stock prices; (3) differential managerial efficiency, which implies that a new management can increase the value of the firm's operating assets; and (4) increased market power due to reduced competition. Operating and financial economies are socially desirable, as are mergers that increase managerial efficiency, but mergers that reduce competition are undesirable, and antitrust laws are in place to prohibit such mergers. If one agrees that our tax laws are reasonable, and that tax avoidance is reasonable, tax considerations represent a socially valid rationale for mergers. Without the merger, the unprofitable company might be able to use its tax carry-forwards eventually, but their value would be higher if used as the basis for a merger. Merger motives that are questionable on economic grounds are diversification, purchase of assets below replacement cost, and control. Managers often state that diversification helps to stabilize a firm's earnings and reduces total risk, hence benefits shareholders. Stabilization of earnings is certainly beneficial to a firm's employees, suppliers, customers, and managers. However, if a stock investor is concerned about earnings variability, he or she can diversify more easily than the firm can. Why should Firm A and Firm B merge to stabilize earnings when stockholders can merely purchase both stocks and accomplish the same thing? Further, we know that well-diversified shareholders are more concerned with a stock's market risk than with its total risk, and higher earnings instability does not necessarily translate into higher market risk. Sometimes a firm will be touted as a possible acquisition candidate because the replacement value of its assets is considerably higher than the firm's market value. For example, in the early 1980s, oil companies could acquire reserves more cheaply by buying out other oil companies than by exploratory drilling. However, the value of an asset stems from its expected cash flow, not from its cost. Thus, paying $1 million for a slide rule plant which would cost $2 million to build from scratch is not much of a deal if no one uses slide rules. In recent years, many hostile takeovers have occurred. To keep their companies independent, and also to protect their jobs, managers sometimes engineer defensive mergers or leveraged managerial buyouts, which make their firms more difficult to digest. In general, defensive mergers appear to be designed more for the benefit of managers than for that of stockholders. It is important for managers to understand these points for at least three reasons: (1) The managers of a firm thinking about making an acquisition must know how others, in general, tend to think about mergers in order to anticipate reactions to a proposed merger. (2) Managers ought to question their own motives; especially, a company's directors ought to question management's motives if a merger is proposed. (3) If antitrust issues are raised, the potential merger partners may have to justify the merger in the courts, and knowledge of both law and economics is essential at that point. Question 2 Briefly describe the differences between a hostile merger and a friendly merger. Is there any reason to think that acquiring companies would, on average, pay a greater premium over target companies’ pre-announcement prices in hostile mergers than in friendly mergers? Answer: In a friendly merger, the management of one firm agrees to be bought out by another firm. In most cases, the acquiring firm initiates the action, but in some situations the target may initiate the merger. The managements of both firms get together and work out terms which they believe to be fair and beneficial to both sets of shareholders. Then, they issue statements to their respective stockholders recommending that they agree to the merger. There is a chance that some other company may decide to make a competing bid and thwart the friendly merger, but barring such an offer, management's support normally assures that the outcome will be favorable. If a target firm's management resists the merger, then the acquiring firm's advances are said to be hostile rather than friendly. In this case, the acquirer must make a direct appeal to the target firm's shareholders. This can take the form of (1) a tender offer, whereby the target firm's shareholders are asked to "tender" their shares to the acquiring firm in exchange for cash, stocks, bonds, or some combination of the three, or (2) a proxy fight. If 51 percent or more of the target shareholders tender their shares or vote for the acquirer, then the merger will probably be completed over management's objection. Though, that de facto, for tax and other reasons, it often takes more than 50 percent control to make a merger feasible, so management may be able to block a hostile takeover attempt with considerably less than 50 percent of the stock. Presumably, in hostile situations the target firm's management makes every effort to get the best price for the company, whereas in a friendly merger management might be willing to see the company go for a low price so that they can get good positions in the surviving company. The motives and reasons are speculative, but evidence does show that larger premiums occur in hostile mergers. Question 3 Complete CCI’s cash flow statements for 1996 through 1999. Why is interest expense typically deducted in merger cash flow statements, whereas it is not normally deducted in capital budgeting cash flow analysis? Why are retained earnings deducted to obtain the free cash flows? Answer: CCI's cash flow statements, assuming the acquisition is made, are shown above in the model description section. Note that these statements are identical to standard capital budgeting cash flow statements, except that both interest expense and required retentions are included in the merger analysis. In straight capital budgeting, all debt involved is new debt issued to finance the asset being acquired. Hence, all the debt costs the same, kd, and this cost is accounted for by discounting the cash flows at the firm's WACC. In a merger, however, the acquiring firm usually assumes the existing debt of the target, and new debt is also issued to help finance the takeover. Thus, the debt involved has different costs; hence, it cannot be accounted for as a single cost in the WACC. The solution is to include interest expense explicitly in the cash flow statement. With regard to required retentions, all the cash flows from an individual project are available for use throughout the firm, but some of the cash flows generated by an acquisition must generally be retained within the new division to help finance its growth. Since such retentions are not available to the parent company for use elsewhere, they must be deducted in the cash flow statement. With interest expense and retentions included in the cash flow statements, the cash flows are residuals which belong to the equity holders. CompuTech's management could pay the free cash flows out as dividends, reinvest them elsewhere in the firm, retire debt, or do anything else they see fit. The situation here is a bit like finding the value of a share of stock as the PV of the expected future dividends. If we found the value of a stock as the PV of the earnings, that would overstate the true value. Similarly, if we valued the merger as the PV of the cash flows without recognizing that some cash flows must be retained to generate future cash flows, we would overvalue the merger. Question 4 Conceptually, what is the appropriate discount rate to apply to the cash flows developed in Question 3? What is the numerical value of the discount rate? How much confidence can one place in this estimate, i.e., is the estimated discount rate likely to be in error by a small amount, such as 1 percentage point, or a large amount, such as 4 or 5 percentage points? Would an error in the discount rate have much of an effect on the maximum offer price? Answer: As discussed above, the cash flows are residuals, hence, they belong to the shareholders. Since interest expense has already been considered, the cash flows are equity flows, so they must be discounted using the cost of equity rather than the WACC. Also, the discount rate must reflect the riskiness of the flows, and these cash flows have CCI's business risk, not CompuTech’s business risk, plus its financial risk because interest has been deducted. Though, that the risk of the CCI Division is not the same as CCI’s risk if it operated independently, because the merger would lead to a change in CCI's leverage and its tax rate. To estimate the CCI Division's beta, we can first unlever CCI's market beta of 1.6 using Hamada's equation: bLUnlevered beta = bU = 1 + (1 – T)(D/S) . 1.6 1.6 1.6 = 1 + (1 – 0.30)(0.10/0.90) = 1 + (0.7)(0.11) = 1.078 = 1.48. Note that the pre-merger tax rate and debt to equity ratio are used to unlever the beta. The resulting beta, 1.48, is the inherent beta of CCI's assets—if CCI had zero debt, and hence were unlevered, its beta would be 1.48. Next, this unlevered beta must be "relevered" to reflect the fact that the assets will be operated by CompuTech and will be financed with a debt ratio of 25 percent and subject to a tax rate of 40 percent: bL = bU[1 + (1 — T)(D/S] = 1.48[1+(0.6)(0.25/0.75)] = 1.48(1.2) = 1.78. Thus, to obtain the required rate of return on equity, note that kRF = 6.5% and RPM = 5%. Thus, CCI Division's required rate of return on equity, which is the appropriate discount rate to apply to the merger cash flows, is 15.41%: ks(CCI) = kRF + (RPm)bCCI = 6.5% + (5%) 1.78 = 15.41%. Although the discount rate was calculated to two decimal places, our confidence in its accuracy is low. First, CCI's market beta of 1.60 is merely an estimate of the true beta. Second, historical betas are not particularly good estimates of future market risk. Third, Hamada's equation requires all of the assumptions of the CAPM and of the Modigliani and Miller model, including no financial distress or agency costs. Thus, it can provide only a rough estimate of the effect of the acquisition on CCI's market risk. Finally, it is difficult to estimate the market risk premium at any point in time. For all the reasons stated above, we should view the estimate of the discount rate as only an approximation. Since we do not know the real discount rate, we cannot measure the error. In our opinion, it would probably be 1 to 2 percentage points on either side of the estimate. Therefore, we would definitely be concerned about the sensitivity of the outcome to the discount rate. We used the model to test the sensitivity of the maximum price to the discount rate. Here are the results: K Max Price -------- ----------13.41% $4.64 14.41 4.35 15.41 4.11 16.41 3.90 17.41 3.71 The cost of equity is probably within the indicated range, and within that range, the offer price is somewhat but not terribly sensitive to discount rate variations. Question 5 What is the terminal value of CCI, that is, what is the 1999 value of the cash flows CCI is expected to generate beyond 1999? What is CCI’s value to CompuTech at the beginning of 1996? Suppose another firm was evaluating CCI as a potential acquisition candidate. Would they obtain the same value? Explain. Answer: The 1999 cash flow available to shareholders is $1,751,114, and it is expected to grow at a constant 5.0 percent rate beyond 1999. With a constant growth rate, the Gordon model can be used to value the cash flows beyond 1999: (1999 Cash flow)(1 + g) Terminal value = ks – g $1,751,114(1.05) = 0.1541 — 0.050 = $17,667,256. The terminal value could be based only on the discounted cash flows beyond 1999. Alternatively, that value could be found as a multiple of book value, earnings, etc. Students generally want to look only at the PV. In the real world, other things might be considered. At any rate, with the terminal value added, the net cash flows are as shown in the cash flow/income statement in the model information section The value of CCI to CompuTech is the present value of the net cash flow stream, discounted at 15.41 percent: $12,333,176, which would be rounded to $ 12 to $12.5 million. If another firm were valuing CCI, it would probably obtain a different estimate of the value. Most important, the synergies involved would likely differ, causing the projected cash flow estimates to differ. Also, another potential acquirer might use more or less debt, hence estimate a different discount rate. The tax rate could also be different, which would change both the cash flows and the discount rate. Finally, the other acquirer's managers might be more or less optimistic about CCI's future, or more or less eager to control a larger enterprise, so the offer price could differ even if the valuation were the same. There is potential strategic option value inherent in this merger. CompuTech has the potential to grow more rapidly than CCI could on its own by offering a wider variety of software products, hence to grow faster than the projected 20 percent. If things work out well, there is no reason that CompuTech could not add more software product to its line, and greatly increase its value. Strategic option value is not built into the cash flows, so it could cause CompuTech or some other bidder to raise the price. Question 6 a. CCI’s management has a substantial ownership interest in the company, but not enough to block a merger. If CCI’s managers want to keep the firm independent, what are some actions they could take to discourage potential suitors? Answer: Some commonly used techniques to keep a firm independent include (1) a leveraged buyout, (2) some type of poison pill, such as requiring a supermajority of stockholders to vote for a merger, (3) setting up an ESOP, which would own a sizable block of stock which presumably would be voted in management's favor, and (4) issuing a lot of debt and using the funds to repurchase common stock. However, none of these actions would seem appropriate for CCI at this time. b. If CCI’s managers conclude that they cannot remain independent, what are some actions they might take to help their stockholders (and themselves) get the maximum price for their stock? Answer: The most obvious tactics are (1) to present any data or other factors in the most favorable light, (2) to have an appraisal of value done for use in the negotiation process, and (3) to seek other bids from other potential acquires. The company may be possible to use some of the tactics noted in Part a to ward off the merger, but if a merger is inevitable, then soliciting competitive bid is the most logical way of getting the highest price for the stock. Generally, larger companies hire an investment-banking firm to perform an independent valuation and to seek out other bidders. c. If CCI’s managers conclude that the maximum price others are willing to bid for the company is less than its “true value,” is there any other action they might take that would benefit both outside stockholders and the managers themselves? Explain. Answer: If management is convinced that the company is worth more than any outsider is willing to pay, then it can make its views known to investors and attempt to jawbone the stock price up above the bid price. That tactic rarely works. The only other thing we can think of is to attempt to put together a leveraged managerial buyout. That might work, especially if the present management is regarded as being especially competent, and if the management would stay with the firm if a LBO occurs but resign if a hostile takeover occurs, this tactic works best if "people are the only asset," as is often true of service companies such as those in the securities business. An example of this was Mellon Bank's acquisition of Boston Company, a money management firm, whose top managers left to start a competing company and took most of their clients with them. d. Do CCI’s managers face any potential conflicts of interest (agency problems) in their negotiations with CompuTech? If so, what might be done to reduce conflict of interest problems? Answer: Potential conflicts of interest abound in all merger situations. If a friendly takeover occurs, management might be persuaded to recommend a low price if management itself received good jobs and substantial stock options in the surviving company. In an LBO in which management would participate, it would be in management's own best interest to buy out outside stockholders at the lowest possible price, so potential conflicts of interest clearly exist here. The threat of stockholder suits is one safeguard against managers putting their own interests ahead of those of stockholders as a group. Competition—getting as many parties to bid on the firm as possible is another safeguard. Finally, in most LBOs, and in many mergers, a committee consisting of outside directors who will have no continuing interest in the firm is established to weigh the competing offers and to make a recommendation to outside stockholders. All of these actions occurred in the largest acquisition of all time, the RJR Nabisco deal. Question 7 CCI has 3 million shares of common stock outstanding. The shares are traded infrequently and in small blocks, but the last trade, of 500 shares, was at a price of $1.50 per share. Based on this information, and on your answers to Questions 5 and 6, how much should CompuTech offer for CCI, and how should it go about making the offer? Answer: With a current price of $1.50 per share and 3 million shares outstanding, CCI's current market value is $1.50(3) = $4.5 million. Since CCI's expected value to CompuTech is about $12.3 million, it appears that the merger would be beneficial to both sets of stockholders. The difference, $12.3 —— $4.5 = $7.8 million, is the synergistic value available for apportionment between the stockholders of the two firms. The offer range is from $1.50 per share to $12,333,176/3,000,000 = $4.11 per share. If the price were set at $4.11, all of the expected benefits of the merger would go to CCI's shareholders, while at $1.50, all of the added value would go to CompuTech's shareholders. If CompuTech offers more than $4.11 per share, then wealth would be transferred from its stockholders to CCI's stockholders. However, as discussed below, there may be some potential strategic option value not captured in the DCF analysis that would warrant a higher bid. Setting the actual offer price is a matter of judgment. Obviously, CompuTech would like to acquire CCI at a price as low as possible. Most mergers involve a premium of 25 to 75 percent over the previous price, but it is never clear if it would be better to make a low initial offer, say $1.90 per share, or a high price, say $3.50, which would pass most of the synergistic gain to CCI's stockholders but would perhaps scare off potential rivals. CompuTech's management should consider carefully what both CCI's managers and other potential bidders might do after the offer has been placed on the table. Ideally, CompuTech would determine the most that a competing bidder would be likely to offer, and then offer just over that amount. This would be termed a preemptive offer, as it would preempt other parties and keep them out of the bidding. Of course, CompuTech might conclude that synergistic values were no greater to it than to several other firms, hence that it would not be possible to make a preemptive offer without giving up all the synergistic gain. In that case, CompuTech should acquire the maximum amount of CCI's stock permitted by law (5 percent) before making any announcements or overtures, and then try to move rapidly to effect a takeover before competition can develop. Then, even if CompuTech is not the eventual winner, it can still profit as a CCI stockholder when someone else buys the company. CompuTech's managers would also have to make a decision as to whether to try for a friendly merger or to anticipate that CCI's management would be hostile. This would depend on many things, but most importantly, on how much of the stock CCI's managers controlled and how important it was to have CCI's management remain with the company after the acquisition. Here management controls a large block of the stock, and CompuTech would like to retain CCI's managers, so they should try to effect a friendly deal. If that were not the case, then the issue would hinge on what procedure would be most likely to produce the best results. Question 8 Do you agree that synergistic effects probably create value in the average completed merger? If so, what determines how this value is shared between the stockholders of the acquiring and acquired companies? On average, would you expect more of the value to go to the acquired or to the acquiring firm? Explain your answers. Empirical studies have covered every significant merger from the early 1960s to the present, and they are remarkably consistent in their results: On average, the stock prices of target firms increase by about 30 percent in hostile tender offers, while in friendly mergers the average increase is about 20 percent. However, for both friendly mergers and hostile tender offers, the stock prices of acquiring firms, on average, remain constant. Therefore, the evidence strongly indicates (1) that acquisitions do create value, (2) that the value created amounts to about 20 percent in friendly mergers and 30 percent in hostile mergers, and (3) that the shareholders of target firms reap virtually all of the gains produced in mergers. In hindsight, these results are not too surprising. First, target firms' shareholders can always say "no," so they can hold out for top dollar. Second, takeovers are a competitive game, so if one potential acquirer is not willing to offer close to full value, There will probably be room for another to step in. Third, managements of acquiring firms might well be willing to give up all the value created in a merger to target firms' shareholders, because this enhances the acquiring managers' personal positions, but no cost on their own shareholders. And fourth, the difference in premiums between friendly and hostile mergers can probably be explained by the fact that in friendly deals the acquiring firm generally wants to retain the target firm's managers, and this probably means that the managers have done a good job and thus caused the value of the firm, pre-merger, to be closer to the attainable level, which means that there is less room for cost-cutting based synergies, hence less potential for offering a large premium. It has also been argued that acquisitions may increase shareholder wealth at the expense of bondholders. In particular, concern has been expressed that leveraged buyouts dilute the claims of bondholders. Many examples can be cited where bonds were downgraded and bondholders suffer losses as a direct result of an acquisition, but counter examples can also be offered. Question 9 A major concern when analyzing any merger is the accuracy of the cash flows. How would the maximum price vary if the variable cost percentage were greater or less than the expected 80 percent? If you are using the spreadsheet model, do a sensitivity analysis on the variable cost ratio, and also determine the maximum percentage that would justify a price of $3.50 per share. If you do not have access to the spreadsheet model, simply discuss the issue, and explain why managers would be interested in such a sensitivity analysis. It is obvious that CCI's variable costs are just an educated guess, so it would definitely be useful to know how much of an effect variations in variable costs would have on CCI's value, because this would tell us something about the riskiness of the acquisition to CompuTech. We first used the spreadsheet model to see how high the VC ratio could go before the offer price declined to $ 3.50. We simply put the cursor on the VC percentage and increased it until the offer price declined $3.50; the VC percentage was 82.15 percent. We also used a data table to perform a sensitivity analysis on the maximum price CompuTech could pay at different variable cost and fixed cost percentages; the results are shown below: Variable Price per Share at Different Fixed Costs Costs 15% 20% 25% 65% $8.76 $8.39 $8.02 70 7.33 6.96 6.60 75 5.91 5.54 5.17 80 4.48 4.11 3.74 85 3.05 2.68 2.32 90 1.63 1.26 0.89 95 0.20 -0.17 -0.54 100 1.23 -1.59 -1.96 If variable costs are 80 percent and fixed costs are 20 percent, which is the base case, the maximum price is $4.11; this value is shown underlined in the middle of the table. Going down the columns shows that for any given fixed cost, value declines sharply as variable cost rise. Similarly, going across any of the rows shows that value declines as fixed costs rise. If cost get too high, losses will be incurred, and CompuTech should simply not acquire CCI. Sensitivity analysis could also be done on other variables, such as the cost of capital and growth rates. However, it is worth noting that under certain conditions the model gives invalid results. For example, the model gives unreasonable output if the growth rates are too high or too low. This is fairly typical with spreadsheet model—they are designed to give reasonable results within certain parameter ranges, but not if the data extend beyond those ranges. In this case, very high or very low growth rates lead, through the use of the Gordon growth model, to nonsense valuations. If those growth rates were actually expected, it would be necessary to modify the model, probably by extending the columns on out for a number of years before reaching the normal growth period. Question 10 What rate of return on equity is projected in the analysis? Should the projected ROE make you want to question the assumptions that went into the cash flow and financial statement projections? Answer: The projected ROEs are high, going up to approximately 39 percent in 1999. Such high returns would probably attract competition, which might drain off customers and lead to price reductions, both of them would affect profits and the ROE. So, while the numbers are not too optimistic, these high returns should lead to sharp questions about the validity of the projections. In the long run, such high returns would clearly not be sustainable. However, they could be earned over the next few years. Our inclination would be to modify the model, extending the years on out to 2010 or so, and show the results under conditions which led to a gradual decline in ROE to something closer to the norm for all firms, say somewhere in the 12 to 16 percent range. Question 11 Would the response of CCI’s stockholders be affected by whether the offer was for cash or for stock in CompuTech? Explain. Answer: Stockholders generally prefer stock to cash if the target firm's price has appreciated greatly, because if more than 50 percent of the price paid is in the form of common of preferred stock, then the capital gains tax can be deferred. Therefore, a lower price can generally be offered in a stock deal. However, if cash is offered, the deal can generally be completed sooner, because then there will be less SEC involvement to determine if representation as to the value of the stock are correct, and a faster deal can mean a lower cost deal. Question 12 What are your final conclusions? Should CompuTech make an offer, and if so, should they try for a friendly deal; what price per share should they offer; how should they make payment; and should they try to retain the present management? Answer: CompuTech actually offered $3.10 in cash, and a friendly merger occurred at a price of $3.55. CCI's current managers were retained to run the operation, under CompuTech's direction, and they were given a compensation package that helped persuade them to support the merger. No other bidders entered the fray, in part because of management's support for CompuTech and in part because CompuTech's initial offer was toward the high end of the value range. Part of CompuTech's thinking was that the chance existed to greatly increase the variety of software packages offered by the firm, consequently increasing sales and the firm's growth rate. Whereas CCI, operating independently, was limited in the software it could offer for sale. Even if CompuTech's rate of return on investment declined a bit, the growth rate in earnings could still be terrific. Thus, CompuTech regarded the merger in two ways: (1) they were buying an existing financial software company and paying a fairly high price for it. (2) they were also getting a strategic option to invest a lot of money at a good rate of return to offer additional software packages if things worked out well.
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