Deck 21: Mergers, Lbos, Divestitures, and Holding Companies

Question 1

Merger activity is likely to heat up when interest rates are high because target firms can expect to receive an especially high premium over the pre-announcement stock price.

Answer 1

False

Question 2

Leveraged buyouts (LBOs) occur when a firm's managers, generally backed by private equity groups, try to gain control of a publicly owned company by buying out the public shareholders using large amounts of borrowed money.

Answer 2

True

Question 3

One of the main reasons why foreign firms are interested in buying U.S. companies is to gain entrance to the U.S. market. A decline in the value of the dollar relative to most foreign currencies makes this competitive strategy especially attractive.

Answer 3

True

Question 4

A joint venture is one in which 2, or sometimes more, independent companies agree to combine resources in order to achieve a specific objective, usually limited in scope.

Question 5

Since the primary rationale for any operating merger is synergy, in planning such mergers, the development of accurate pro forma cash flows is the single most important action.

Question 6

The two principal advantages of holding companies are (1) the holding company can control a great deal of assets with limited equity and (2) the dividends received by the parent from the subsidiary are not taxed if the parent holds at least 50% of the subsidiary's stock.

Question 7

Currently (2007), mergers can be accounted for using either the purchase method or the pooling method.

Question 8

Most defensive mergers occur as a result of managers' actions to maximize shareholders' wealth.

Question 9

If a petrochemical firm that used oil as feedstock merged with an oil producer that had large oil reserves and a drilling subsidiary, this would be a vertical merger.

Question 10

Synergistic benefits can arise from a number of different sources, including operating economies of scale, financial economies, and increased managerial efficiency.

Question 11

Post-merger control and the negotiated price paid by the acquirer are 2 of the most important issues in agreeing on the terms of a merger.

Question 12

Borrowing funds on terms that would require immediate repayment of all funds if the firm is acquired, selling off valuable assets, and granting huge "golden parachutes" that open if the firm is acquired are 3 procedures used to defend against hostile takeovers. These strategies are known as "poison pills."

Question 13

A spin-off is a type of divestiture in which the assets of a division are sold to another firm.

Question 14

The primary reason managers give for most mergers is to acquire more assets so as to increase sales and market share.

Question 15

In a merger with true synergies, the post-merger value exceeds the sum of the separate companies' pre-merger values.

Question 16

A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine.

Question 17

A company seeking to fight off a hostile takeover might employ the services of an investment banking firm to develop a defensive strategy.

Question 18

A congeneric merger is one where the merging firms operate in related businesses but do not necessarily produce the same products or have a producer-supplier relationship.

Question 19

The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers.

Question 20

Since managers' central goal is to maximize stock price, managerial control issues do not interfere with mergers that would benefit the target firm's stockholders.

Question 21

If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the horizon value is calculated by discounting the free cash flows plus the expected future tax shields at the weighted average cost of capital.

Question 22

A two-tier merger offer is one where the acquiring company offers to purchase the target company in a two-part transaction. Cash is paid to some stockholders, bonds are issued to others, but the total values of each part of the transaction are equal.

Question 23

Which of the following statements is most CORRECT?

A) A conglomerate merger is one where a firm combines with another firm in the same industry.
B) Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm.
C) Defensive mergers are designed to make a company less vulnerable to a takeover.
D) Hostle mergers always create value for the acquiring firm.
E) In a tender offer, the target firm's management always remain after the merger is completed.

Question 24

Firms use defensive tactics to fight off undesired mergers. These tactics do not include

A) raising antitrust issues.
B) getting a white squire to purchase stock in the firm.
C) getting white knights to bid for the firm.
D) repurchasing their own stock.
E) changing the bylaws to eliminate supermajority voting requirements.

Question 25

The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt.

Question 26

Which of the following statements is most CORRECT?

A) The acquiring firm's required rate of return in most horizontal mergers will not be affected, because the 2 firms will have similar betas.
B) Financial theory says that the choice of how to pay for a merger is really irrelevant because, although it may affect the firm's capital structure, it will not affect its overall required rate of return.
C) The basic rationale for any financial merger is synergy and, thus, the estimation of proforma cash flows is the single most important part of the analysis.
D) In most mergers, the benefits of synergy and the premium the acquirer pays over the market price are summed and then divided equally between the shareholders of the acquiring and target firms.
E) The primary rationale for most operating mergers is synergy.

Question 27

Any goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes.

Question 28

Which of the following are legal and acceptable reasons for the high level of merger activity in the U.S. during the 1980s?

A) Synergistic benefits arising from mergers.
B) A profitable firm acquires a firm with large accumulated tax losses that my be carried forward.
C) Attempts to stabilize earnings by diversifying.
D) Purchase of assets below their replacement costs.
E) Reduction in competition resulting from mergers.

Question 29

In a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the 2 companies, measured as if they were operated independently.

Question 30

Only if a target firm's value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified.

Question 31

Which of the following statements about valuing a firm using the APV approach is most CORRECT?

A) The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.
B) The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.
C) The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity.
D) The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity.
E) The APV approach stands for the accounting pre-valuation approach.

Question 32

Since a manager's central goal is to maximize the firm's stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team.

Question 33

The 3 main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks.

Question 34

Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated.

Question 35

Coca-Cola's acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately could be described as primarily a financial merger.

Question 36

The rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm.

Question 37

The distribution of synergistic gains between the stockholders of 2 merged firms is almost always based strictly on their respective market values before the announcement of the merger.

Question 38

Although goodwill created in a merger may not be amortized for shareholder reporting purposes, it may be amortized for Federal tax purposes.

Question 39

Which of the following statements is most CORRECT?

A) Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.
B) The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed.
C) Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger.
D) Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what's probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm.
E) Operating economies are never a motive for mergers.

Question 40

Which of the following statements about valuing a firm using the APV approach is most CORRECT?

A) The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.
B) The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt.
C) The horizon value is calculated by discounting the expected earnings at the WACC.
D) The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC.
E) The horizon value must always be more than 20 years in the future.

Question 41

Brau Auto, a national autoparts chain, is considering purchasing a smaller chain, South Georgia Parts (SGP). Brau's analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue enough new debt to continue at the 30% target level. The interest rate would remain the same. SGP's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8% and the market risk premium is 4%. What is the value of SGP to Brau?

A) $53.40 million
B) $61.96 million
C) $64.64 million
D) $76.96 million
E) $79.64 million

Question 42

Great Subs Inc., a regional sandwich chain, is considering purchasing a smaller chain, Eastern Pizza, which is currently financed using 20% debt at a cost of 8%. Great Subs' analysts project that the merger will result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Eastern's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%. What is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

A) 12.0%
B) 13.9%
C) 14.4%
D) 16.0%
E) 16.9%

Question 43

(The following data apply to Problems 53 through 55. The problems MUST be kept together.)
Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02, and both it and Dustvac face a 40% tax rate. Magiclean's capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.
What is the value of Dustvac's equity to Magiclean? (Round your answer to the closest thousand dollars.)

A) $16,019,000
B) $17,111,000
C) $18,916,000
D) $22,111,000
E) $22,916,000

Question 44

Dunbar Hardware, a national hardware chain, is considering purchasing a smaller chain, Eastern Hardware. Dunbar's analysts project that the merger will result in incremental free flows and interest tax savings with a combined present value of $72.52 million, and they have determined that the appropriate discount rate for valuing Eastern is 16%. Eastern has 4 million shares outstanding and no debt. Eastern's current price is $16.25. What is the maximum price per share that Dunbar should offer?

A) $16.25
B) $16.97
C) $17.42
D) $18.13
E) $19.00

Question 45

Kelly Tubes is considering a merger with Reilly Tires. Reilly's market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Kelly acquires Reilly, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What will Reilly's required rate of return on equity be after it is acquired?

A) 7.4%
B) 8.9%
C) 9.3%
D) 9.6%
E) 9.7%

Question 46

Which of the following statements is most CORRECT?

A) Leveraged buyouts (LBOs) occur when a firm issues equity and uses the proceeds to take a firm public.
B) In a typical LBO, bondholders do well but shareholders see their value decline.
C) Firms are forbidden by law to sell any assets during the first five years following a leverage buyout.
D) LBOs are never backed by private equity firms.
E) LBOs typically use a lot of debt.

Question 47

Blazer Inc. is thinking of acquiring Laker Company. Blazer expects Laker's NOPAT to be $9 million the first year, with no net new investment in operating capital and no interest expense. For the second year, Laker is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year only, Laker will need $10 million of net new investment in operating capital. Laker's marginal tax rate is 40%. After the second year, the free cash flows and the tax shields from Laker to Blazer will both grow at a constant rate of 4%. Blazer has determined that Laker's cost of equity is 17.5%, and Laker currently has no debt outstanding. Assume that all cash flows occur at the end of the year, Blazer must pay $45 million to acquire Laker. What it the NPV of the proposed acquisition? Note that you must first calculate the value to Blazer of Laker's equity.

A) $ 45.0 million
B) $ 68.2 million
C) $ 86.5 million
D) $113.2 million
E) $133.0 million

Question 48

Which of the following statements is most CORRECT?

A) Firms that are acquired usually have a market price below book value before the merger offer is made. However, once the initial offer is made, the price can rise above book value, but the purchase price, especially in large acquisitions, generally remains within 20% of book value.
B) When Texaco purchased Getty Oil, many financial analysts felt that the deal made sense because it increased Texaco's market share and expanded its shrinking oil reserves. This merger exemplified the belief among the natural resource companies that buying reserves through acquisitions was less costly than exploring and finding them in the field.
C) When Mobil Oil Company tried to acquire Conoco, which was another oil company, stockholders were concerned that the U.S. Justice Department would try to block the merger because it would lessen competition. Thus, antitrust considerations affected this proposed horizontal merger.
D) Answers b and c are correct.
E) All of the statements above are false.

Question 49

Which of the following statements is most CORRECT?

A) If a company that produces military equipment merges with a company that manages a chain of motels, this is an example of a horizontal merger.
B) A defensive merger is one where the firm's managers decide to merge with another firm to avoid or lessen the possibility of being acquired through a hostile takeover.
C) Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition.
D) Cash payments are used in takeovers but never in mergers.
E) Managers often are fired in takeovers, but never in mergers.

Question 50

A parent holding company sells shares in its subsidiary such that the parent now owns only 65% of the subsidiary and, thus, the tax returns of the parent and its subsidiary can't be consolidated. The parent receives annual dividends from the subsidiary of $2,500,000. If the parent's marginal tax rate is 34% and if the exclusion on intercompany dividends is 70%, what is the effective tax rate on the intercompany dividends, and how much net dividends are received?

A) 10.2%; $2,245,000
B) 10.2%; $2,135,000
C) 23.8%; $1,905,000
D) 10.2%; $1,750,000
E) 34.0%; $1,650,000

Question 51

(The following data apply to Problems 53 through 55. The problems MUST be kept together.)
Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02, and both it and Dustvac face a 40% tax rate. Magiclean's capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.
What Dustvac's pre-merger WACC?

A) 9.02%
B) 9.50%
C) 9.83%
D) 10.01%
E) 11.29%

Question 52

(The following data apply to Problems 53 through 55. The problems MUST be kept together.)
Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02, and both it and Dustvac face a 40% tax rate. Magiclean's capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.
What discount rate should you use to discount Dustvac's free cash flows and interest tax savings?

A) 10.01%
B) 10.06%
C) 11.29%
D) 11.44%
E) 13.49%