If the cash flows of the acquiring and target firms are less than perfectly correlated, the cash flows of the combined firm will be less variable than the cash flows of the individual firms. This decrease in variability can result in an increase in debt capacity and in the value of the firm. The increase in value, however, has to be weighed against the immediate transfer of wealth to existing bondholders in both firms from the stockholders of both the acquiring and target firms.

The bondholders in the pre-merger firms find themselves lending to a safer firm after the takeover. The coupon rates they are receiving are based upon the riskier pre-merger firms, however. If the coupon rates are not renegotiated, the bonds will increase in price, increasing the bondholders’ wealth at the expense of the stockholders. There are several models available for analyzing the benefits of higher debt ratios as a consequence of takeovers. Lewellen analyzes the benefits in terms of reduced default risk, since the combined firm has less variable cash flows than do the individual firms. He provides a rationale for an increase in the value of debt after the merger, but at the expense of equity investors.

It is not clear, therefore, that the value of the firm will increase after the merger. Stapleton evaluates the benefits of higher debt capacity after mergers using option pricing. He shows that the effect of a merger on debt capacity is always positive, even when the earnings of the two firms are perfectly correlated. The debt capacity benefits increase as the earnings of the two firms become less correlated and as investors become more risk averse. Consider again the merger of Lube & Auto and Dalton Motor. The value of the combined firm was the same as the sum of the values of the independent firms.

The fact that the two firms were in different business lines reduced the variance in earnings, but value was not affected, because the capital structure of the firm remain unchanged after the merger, and the costs of equity and debt were the weighted averages of the individual firms' costs. The reduction in variance in earnings can increase debt capacity, which can increase value. If, after the merger of these two firms, the debt capacity for the combined firm were increased to 40% from 30% (leading to an increase in the beta to 1.21 and no change in the cost of debt), the value of the combined firm after the takeover can be estimated as shown in Table 26.7.

As a consequence of the added debt, the value of the firm will increase from $9,781.38 million to $11,429.35 million.

--> CC 26.3: In the example described above, what would happen to stockholder wealth, if the merger went through and the combined firm’s debt was kept at pre-merger levels? What would happen to bond prices?

Increase Growth and Price-Earnings Multiples

Some acquisitions are motivated by the desire to increase growth and price-cash flow (or price-earnings) multiples. Though the benefits of higher growth are undeniable, the price paid for that growth will determine whether such acquisitions make sense. If the price paid for the growth exceeds the fair market value, the stock price of the acquiring firm will decline even though the expected future growth in its cash flows may increase as a consequence of the takeover. This can be seen in the previous example.

Dalton Motor, with projected growth in cash flows of 10%, acquires Lube & Auto, which is expected to grow 20%. The fair market value for Lube & Auto is $4,020.91. If Dalton Motor pays more than this amount to acquire Lube & Auto, its stock price will decline, even though the combined firm will grow at a faster rate than Dalton Motor alone. Similarly, Dalton Motor, which sells at a lower multiple of cash flow than Lube & Auto, will increase its value as a multiple of cash flow after the acquisition, but the effect on the stockholders in the firm will still be determined by whether or not the price paid on the acquisition exceeds the fair value.

Takeover Valuation: Biases and Common Errors

The process of takeover valuation has potential pitfalls and biases that arise from the desire of the management of both the bidder and target firms to justify their points of view to their stockholders. The bidder firm aims to convince its stockholders that it is getting a bargain (i.e., that it is paying less than what the target firm is truly worth). In friendly takeovers, the target firm attempts to show its stockholders that the price it is receiving is a fair price (i.e., it is receiving at least what it is worth).

In hostile takeovers, there is a role reversal, with bidding firms trying to convince target firm stockholders that they are not being cheated out of their fair share, and target firms arguing otherwise. Along the way, there are a number of common errors and biases in takeover valuation.

Use of Comparable Firms and Multiples

The prices paid in most takeovers are justified using the following sequence of actions: the acquirer assembles a group of firms comparable to the one being valued, selects a multiple to value the target firm, computes an average multiple for the comparable firms and then makes subjective adjustments to this “average”. Each of these steps provides an opening for bias to enter into the process. Since no two firms are identical, the choice of comparable firms is a subjective one and can be tailored to justify the conclusion we want to reach.

Similarly, in selecting a multiple, there are a number of possible choices - priceearnings ratios, price-cash flow ratios, price-book value ratios, and price-sales ratios, among others- and the multiple chosen will be the one that best suits our biases. Finally, once the average multiple has been obtained, subjective adjustments can be made to complete the story. In short, there is plenty of room for a biased firm to justify any price, using reasonable valuation models.

Mismatching Cash Flows and Discount Rates

One of the fundamental principles of valuation is that cash flows should be discounted using a consistent discount rate. Cash flows to equity should be discounted at the cost of equity and cash flows to the firm at the cost of capital, nominal cash flows should be discounted at the nominal discount rate and real cash flows at the real rate, aftertax cash flows at the after-tax discount rate, and pre-tax cash flows at the pre-tax rate. The failure to match cash flows with discount rates can lead to significant under or over valuation. Some of the more common mismatches include:

(1) Using the bidding firm's cost of equity or capital to discount the target firm's cash flows: If the bidding firm raises the funds for the takeover, it is argued, its cost of equity should be used. This argument fails to take into account the fundamental investment principle that it is not who raises the money that determines the cost of equity as much as what the money is raised for. The same firm will face a higher cost of equity for funds raised to finance riskier projects and a lower cost of equity to finance safer projects. Thus, the cost of equity in valuing the target will reflect that firm’s riskiness, i.e., it is the target firm's cost of equity. Note, also, that since the cost of equity, as we have defined it, includes only non-diversifable risk, arguments that the risk will decrease after the merger cannot be used to reduce the cost of equity, if the risk being decreased is firm-specific risk.

(2) Using the cost of capital to discount the cash flows to equity: If the bidding firm uses a mix of debt and equity to finance the acquisition of a target firm, the argument goes, the cost of capital should be used in discounting the target firm's cash flows to equity (cash flows left over after interest and principal payments). By this reasoning, the value of a share in IBM to an investor will depend upon how the investor finances his or her acquisition of the share - increasing if the investor borrows to buy the stock (since the cost of debt is less than the cost of equity) and decreasing if the investor buys the stock using his or her own cash. The bottom line is that discounting the cash flows to equity at the cost of capital to obtain the value of equity is always wrong and will result in a significant overvaluation of the equity in the target firm.

Subsiding the Target Firm

The value of the target firm should not include any portion of the value that should be attributed to the acquiring firm. For instance, assume that a firm with excess debt capacity or a high debt rating uses a significant amount of low-cost debt to finance an acquisition.

If we estimated a low cost of capital for the target firm, with a high debt ratio and a low after-tax cost of debt, we would over estimate the value of the firm. If the acquiring firm paid this price on the acquisition, it would represent a transfer of wealth from the acquiring firm’s stockholders to the target firm’s stockholders. Thus, it is never appropriate to use the acquiring firm’s cost of debt or debt capacity to estimate the cost of capital for the target firm.

Prof. Aswath Damodaran

Next: Structuring the Acquisition

Summary: Index