ENGINEERING FINANCE
EMIS 8363 / EF 720-N
Summer 2002
(Lecture # 16 )
Mergers, LBOs, Divestitures
and Holding Companies
The most dramatic growth and largest increases in firms’ stock prices from mergers.
Leverage buyouts (LBOs) – firm’s stock is acquired by a small group of investors rather
than by another operating company
Divestitures – divest or sell off to other firms that can better utilize the divested assets
Holding company – one corporation owns the stock of one or more other companies
Motives behind corporate mergers:
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Synergy
 Operating economies
 Financial economies
 Tax effects
 Differential efficiency
 Increased market power
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Tax Considerations
Tax savings are often less than the premium paid in the acquisition
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Purchase of assets below their replacement cost
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Diversification
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Manager’s personal incentives
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Breakup value
Types of mergers:
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Horizontal
Vertical
Congeneric
Conglomerate
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Friendly merger - is supported by both the managements of both firms
Hostile merger - is resisted by the target firm’s management, must get 51% control
through tender offer
Valuing the Target Firm
1. Discounted cash flow approach (DCF)
Equity residual method – net residual cash flows that belong solely to the acquiring
firm’s share holders. This method is normally used in DCF calculation rather than the
free cash flow. DC rate is the cost of equity and not the WACC.
Due Diligence – the process of rigorously going over the books and estimating the true
value of corporation’s assets, expenses and other contractual liabilities.
2. Market multiple method
Market determined multiples of net income, EPS, Sales, Book value etc.
Example
Postmerger control
Taxes and the structure of the takeover bid
Financial Reporting of Mergers:
 Pooling of interests accounting
 Purchase accounting
Role of Investment Bankers
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Identifying targets
Arranging mergers
Developing defensive tactics – poison pills, golden parachutes
Establishing a fair value
Financing mergers
Arbitrage operation
Do mergers really create value?
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According to empirical evidence, acquisitions do create value as a result of
economies of scale, other synergies and/or better management.
Shareholders of target firms reap most of the benefits, that is, the final price is close
to full value
 Target management can always say no.
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Competing bidders often push up prices
Corporate or strategic alliances & joint ventures
 Access to new markets and technologies
 Sharing risks and expenses
 Rivals working together harmoniously
 Shelter cooperative R&D activities
Leverage Buyouts
Divestitures & Spin-offs
Holding Companies – A holding company is a corporation formed for the sole purpose of
owning stocks of other companies. The subsidiary companies issue their own debt, but
their equity is held by the holding company, which, in turn, sells stocks to individual
investors.
Advantages:
 Control with fractional ownership
 Isolation of risks
Disadvantages:
 Partial multiple taxation
 Ease of enforced dissolution
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