Mergers and Acquisitions Exercise
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FIN 220 Mergers and Acquisitions Chang Liu 1 The following information relates to Questions 1–5 Modern Auto, an automobile parts supplier, has made an offer to acquire Sky Systems, creator of software for the airline industry. The offer is to pay Sky Systems’ shareholders the current market value of their stock in Modern Auto’s stock. The relevant information used in those calculations is as follows: Modern Auto Sky Systems Share price $40 $25 Number of outstanding shares (millions) 40 15 Earnings (millions) $100 $30 Although the combined company’s total earnings will not increase and are estimated to be $130 million, Charles Wilhelm (treasurer of Modern Auto) argues that there are two attractive reasons to merge. First, Wilhelm says, “The merger of Modern Auto and Sky Systems will result in lower risk for our shareholders because of the diversification effect.” Second, Wilhelm also says, “If our EPS increases, our stock price will increase in line with the EPS increase because our P/E will stay the same.” Sky Systems managers are not interested in the offer by Modern Auto. The managers, instead, approach HiFly, Inc., which is in the same industry as Sky Systems, to see if it would be interested in acquiring Sky Systems. HiFly is interested, and both companies believe there will be synergies from this acquisition. If HiFly were to acquire Sky Systems, it would do so by paying $400 million in cash. 1. The acquisition of Sky Systems by Modern Auto and the acquisition of Sky Systems by HiFly, respectively, would be examples of a: A. vertical merger and a horizontal merger. B. conglomerate merger and a vertical merger. C. conglomerate merger and a horizontal merger. 2. If Sky Systems were to be acquired by Modern Auto under the terms of the original offer, the post-
merger EPS of the new company would be closest to: A. $2.00. B. $2.32. C. $2.63. 3. Are Wilhelm’s two statements about his shareholders benefiting from the diversification effect of the merger and about the increase in the stock price, respectively, correct? The Merger Will Result in Lower Risk for Shareholders Stock Price Will Increase in Line with the EPS Increase A. No No B. No Yes C. Yes No
FIN 220 Mergers and Acquisitions Chang Liu 2 4. Which of the following defenses best describes the role of HiFly in the acquisition scenario? A. Crown jewel B. Pac-Man® C. White knight 5. Suppose HiFly acquires Sky Systems for the stated terms. The gain to Sky Systems shareholders resulting from the merger transaction would be closest to: A. $25 million. B. $160 million. C. $375 million. The following information relates to Question 6 Kinetic Corporation is considering acquiring High Tech Systems. Jim Smith, vice president of finance at Kinetic, is conducting the analysis of High Tech. Smith is aware of several approaches that could be used for this purpose. He plans to consider each of these approaches in his analysis and has collected or estimated the necessary financial data. While discussing his analysis with a colleague, Smith makes two comments. His first comment is: “If there were a pre- announcement run-up in Quadrant’s price because of speculation, the takeover premium should be computed based on the price prior to the run-up.” Smith’s second comment is: “Because the comparable transaction approach is based on the acquisition price, the takeover premium is implicitly recognized in this approach.” 6. Are Smith’s two comments about his analysis correct? A. Both of his comments are correct. B. Both of his comments are incorrect. C. His first comment is correct, and his second comment is incorrect. The following information relates to Questions 7–12 and is based on “Corporate Governance” and this reading Mark Zin and Stella Lee are CEO and CFO, respectively, of Moonbase Corporation. They are concerned that Moonbase is undervalued and subject to a hostile takeover bid. To assess the value of their own firm, they are reviewing current financial data for Jupiter PLC, Saturn Corporation, and Voyager Corporation, three firms they believe are comparable to Moonbase.
FIN 220 Mergers and Acquisitions Chang Liu 3 Relative Valuation Ratio Jupiter Saturn Voyager P/E 23.00 19.50 21.50 P/B 4.24 5.25 4.91 P/CF 12.60 11.40 13.30 Zin believes Moonbase should trade at similar multiples to these firms and that each valuation ratio measure is equally valid. Moonbase has a current stock price of $34.00 per share, earnings of $1.75 per share, book value of $8.50 per share, and cash flow of $3.20 per share. Using the average of each of the three multiples for the three comparable firms, Zin finds that Moonbase is undervalued. Lee states that the low valuation reflects current poor performance of a subsidiary of Moonbase. She recommends that the board of directors consider divesting the subsidiary in a manner that would provide cash inflow to Moonbase. Zin proposes that some action should be taken before a hostile takeover bid is made. He asks Lee if changes can be made to the corporate governance structure in order to make it more difficult for an unwanted suitor to succeed. In response, Lee makes two comments of actions that would make a hostile takeover more difficult. Lee’s first comment is, “Moonbase can institute a poison pill that allows our shareholders, other than the hostile bidder, to purchase shares at a substantial discount to current market value.” Lee’s second comment is, “Moonbase can instead institute a poison put. The put allows shareholders the opportunity to redeem their shares at a substantial premium to current market value.” Zin is also concerned about the general attitude of outside investors with the governance of Moonbase. He has read brokerage reports indicating that the Moonbase governance ratings are generally low. Zin believes the following statements describe characteristics that should provide Moonbase with a strong governance rating. Statement 1
Moonbase’s directors obtain advice from the corporate counsel to aid them in assessing the firm’s compliance with regulatory requirements. Statement 2
Five of the 10 members of the board of directors are not employed by Moonbase and are considered independent. Although not employed by the company, two of the independent directors are former executives of the company and thus can contribute useful expertise relevant for the business. Statement 3
The board’s audit committee is organized so as to have sufficient resources to carry out its task, with an internal staff that reports routinely and directly to the audit committee. Zin is particularly proud of the fact that Moonbase has begun drafting a “Statement of Corporate Governance” (SCG) that will be available on the company website for viewing by shareholders, investment analysts, and any interested stakeholders. In particular, the SCG pays special attention to policies that ensure effective contributions from the board of directors. These policies include the following: Policy 1
Training is provided to directors prior to joining the board and periodically thereafter. Policy 2
Statements are provided of management’s assessment of the board’s performance of its fiduciary responsibilities.
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FIN 220 Mergers and Acquisitions Chang Liu 4 Policy 3
Statements are provided of directors’ responsibilities regarding oversight and monitoring of the firm’s risk management and compliance functions. Zin concludes the discussion by announcing that Johann Steris, a highly regarded ex-CFO of a major corporation, is under consideration as a member of an expanded board of directors. Zin states that Steris meets all the requirements as an independent director, including the fact that he will not violate the interlocking directorship requirement. Steris also will bring experience as a member of the compensation committee of the board of another firm. He also comments that Steris desires to serve on either the audit or compensation committee of the Moonbase board and that good governance practice suggests that Steris would not be prohibited from serving on either committee. 7. The value the CEO estimated based on comparable company analysis is closest to: A. $37.33. B. $39.31. C. $40.80. 8. The divestiture technique that Lee is recommending is most likely: A. a spin-off. B. a split-off. C. an equity carve-out. 9. With regard to poison pills and puts, Lee’s comments are: A. correct. B. incorrect with regard to the poison put. C. incorrect with regard to the poison pill. 10. Which statement by Zin provides the most support for a strong governance rating? A. Statement 1 B. Statement 2 C. Statement 3 11. Which policy of the Statement of Corporate Governance is least likely to ensure effective contributions from the board of directors? A. Policy 1
FIN 220 Mergers and Acquisitions Chang Liu 5 B. Policy 2 C. Policy 3 12. Is Zin’s comment that good governance practice does not preclude Steris from serving on either of the two committees of the Moonbase board correct? A. Yes. B. No, good governance practice precludes Steris from serving on the audit committee. C. No, good governance practice precludes Steris from serving on the compensation committee. The following information relates to Questions 13–15 Josh Logan is a buy-side equity analyst who follows Durtech. Logan’s supervisor believes that Durtech is a likely takeover candidate and has asked Logan to estimate the company’s value per share in the event of an all-stock takeover bid. Logan plans to estimate Durtech’s value per share using three approaches: discounted cash flow, comparable company analysis, and comparable transaction analysis. Durtech has 1.2 million common shares outstanding and no outstanding long-term debt or preferred stock. Logan estimates that Durtech’s free cash flows at the end of the next three years will be $5.0 million, $6.0 million, and $7.0 million, respectively. After Year 3, he projects that free cash flow will grow at 5% per year. He determines the appropriate discount rate for this free cash flow stream is 15% per year. Applying discounted cash flow analysis to the preceding information, Logan determines that Durtech’s fair enterprise value is $61.8 million. In a separate analysis based on ratios, Logan estimates that at the end of the third year, Durtech will be worth 10 times its Year 3 free cash flow. Logan gathers data on two companies comparable to Durtech: Alphatech and Betatech. He believes that price-to-earnings, price-to-sales, and price-to-book-value per share of these companies should be used to value Durtech. The relevant data for the three companies are given in Exhibit 1. Exhibit 1 Valuation Variables for Durtech and Comparable Companies Valuation Variables Alphatech Betatech Durtech Current stock price ($) 72.00 45.00 24.00 Earnings per share ($) 2.00 1.50 1.00 Sales per share ($) 32.00 22.50 16.00 Book value per share ($) 18.00 10.00 8.00 Logan also identifies one recent takeover transaction and analyzes its takeover premium (the amount by which its takeover price per share exceeds its current stock price). Omegatech is comparable to the possible transaction on Durtech. Omegatech had a stock price of $44.40 per share prior to a newspaper report of a takeover rumor. After the takeover rumor was reported, the price rose immediately to $60.30 per share. Eventually, the takeover offer was accepted by Omegatech’s shareholders for $55.00
FIN 220 Mergers and Acquisitions Chang Liu 6 per share. One-year trailing earnings per share for Omegatech immediately prior to the takeover were $1.25 per share. 13. Based on Exhibit 1 and the mean of each of the valuation ratios, Logan’s estimate of Durtech’s value per share should be closest to: A. $30.44. B. $33.67. C. $34.67. 14. Based on the premium on a recent comparable transaction, Logan’s best estimate of the takeover premium for Durtech is closest to: A. 19.9%. B. 23.9%. C. 35.8%. 15. Using comparable transaction analysis, Logan’s estimate of the fair acquisition value per share for Durtech is closest to: A. $35.52. B. $42.59. C. $44.00.
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