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University of Durham

Mergers and Acquisitions


Summative Assignment

By
Samuel Tedjasukmana

April 2007

I. Introduction

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Targeting private firms seems to be the current trend in mergers and acquisitions. In

the US alone, the year 1996 saw 84% increase of takeover deals involving private

firms as the target compared to the previous year (Ang and Kohers, 2001). The total

value of these transactions reached £40 billion.

This paper seeks to investigate the issues surrounding mergers and acquisitions, both

in general and specifically of a privately owned business, as the following: estimating

the value of a privately owned business, determining the value of an acquisition deal

settlement, how to eliminate a competitive bidder, and how asymmetric information

influences company’s corporate financing policies, including those involving merger.

These issues are observed from the acquirer’s point of view, which in this study is

London Globe. The target company is Murdoch Incorporated, and for the purpose of

valuation, McIntosh Corporation (a public company similar to Murdoch in terms of

industry) is used as a comparable company.

London Globe is a construction company, and has been blessed by the current boom

in the housing market. The industry classification for this company is assumed as

Building – residential and commercial (see appendix for details). Murdoch the target

company has the core business of gas pipeline construction and related equipment,

which is similar to a public company, McIntosh Corporation.

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II. The value of the target company and the maximum price of the acquisition

Murdoch Incorporated (Murdoch) is a privately owned business. It does mean that in

the process of searching for its value, some basic principles of comparable method of

valuation should be used. The following analysis uses the information gathered from

the comparable public company, which is the McIntosh Corporation (McIntosh).

Murdoch McIntosh
Shares outstanding 25 millions 30 millions
Share price - £25
Market value of equity - £750 million
Debt £500 million £80 million
β - 1.20
Tax rate 35% 35%
Risk-free rate 8% 8%
Risk premium 8% 8%
Table 1. Preliminary review

There are three main components of valuation: the weighted average cost of capital

(WACC), the free cash flow (FCF), and the expected growth of cash flow items

(Damodaran, 2002). The first step in valuing Murdoch would be to determine the

cost of equity – as a part of WACC calculation – by using McIntosh’s data, both firm-

specific as well as its market information.

The basic assumption underlying this calculation is that both companies are within

the same industry, which also means being in the same market. Therefore, both of

them will have the same risk-free rate, corporate tax rate, and utterly the same risk

premium. Finally, to estimate the β for Murdoch, the calculation should assume that

Murdoch’s β will eventually converge to its industry average β (using McIntosh’s β

as proxy) by the time it goes public (Damodaran, 2002). The detailed calculation

process and results are presented in the following table.

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McIntosh Murdoch Details
l 1.20
β (levered) 1.20 - u   u    u  1.12
β (un-levered) 1.12 -  1 B1T    1  £80m  1  0.35  
β (private entity) - 1.41 Debt-equity  S   £750 m 
ratio  B
B/S = 0.4  p   u  1   1  T      p  1.12  1   1  0.35   0.4   1.41
(target)  S

ke  R f    Rm  R f   ke  8%  1.41 8%   ke  19.28%
Cost of equity 19.28%
NI £200m
Cost of debt 8.85% EBIT   int erest   £50m  £357.69m
1T   1  0.35 
CR = Interest EBIT £357.69m
coverage CR    7.15  Bond rating A  Cost of borrowing = 0.85%
ratio Interest £50m
above the risk-free rate1
kb  R f  spread  8%  0.85%  8.85%
Cost of debt after tax 5.75%
kd  kb  1  T   8.85%  1  0.35   5.75%
S B 1 0.4
WACC 15.42% WACC  ke  kd  19.28%  5.75%  15.42%
BS BS 1.4 1.4
Net Income (projected) £200.00m
EBIT £357.69m
Contingent loss £40.00m
EBIT (corrected) £317.69m
EBIT (1-tax) £206.50m
Investment £50.00m
FCF £156.50m
Expected growth (g) 2%
FCF  1  g  £156.50m  100%  2% 
Value £1,177.67m Value    £1,174.61m
WACC  g 15.59%  2%
Equity value £677.67m Equity  Value  Debt  £1,177.67 m  £500m  £677.67 m
Equity value/share £27.11 EV £677.67 m
EV / share    £27.11
shares 25m

Table 2. Calculation for Murdoch’s (target company) value

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See appendix for more details on the synthetic bond rates
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Comments on results

Since London Globe is a public company, the deal of acquiring Murdoch is not a

private deal. In that sense, the calculation of Murdoch’s cost of capital would have

been different if the deal was private. This very much affects the assumption of what

borrowing rate should be used. Given that Murdoch is a private business, it cannot

generate debt from the market. Instead, it raises debt from bank loans. The interest

rate for this loan is 10 percent for Murdoch [50m/500m x 100%]. This rate does not

resemble Murdoch’s credit rating in the market. Since the nature of the deal is public,

the calculation should use the appropriate rate, which is the bond rate (Damodaran,

2002). Taking into the account the interest coverage ratio, provided as the company’s

information, the bond rate can be estimated to reflect the company’s credit rating in

the market.

Moreover, the fact that Murdoch, with certainty will incur contingent loss, i.e.

lawsuit liability amounting £40 million, and the event is assumed will take place after

the acquisition; London Globe is entitled to get a tax deduction (Maples, 2003).

London Globe saves £14 million worth of tax due to the inclusion of lawsuit liability

(contingent loss) in the valuation of Murdoch.

To convert the information of net income into earnings before interest and tax (EBIT),

the fixed charge of interest should be included as the standard accounting procedure.

However in the next step of determining the FCF, the direct taxation of EBIT is

justified (Damodaran, 1997). The value of FCF estimated is assumed to grow in

perpetuity, which is why the growth rate becomes a multiplying factor of FCF.

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Reliability of the method used, and other methods could have been used

Comparable method used in the calculation carries some limitations. Since only one

company used as a comparison to estimate Murdoch’s cost of equity, assuming they

are in the same field of business, it raises a concern over the estimation’s reliability.

Moreover, the danger of misestimating becomes more apparent when it assumes

McIntosh as the proxy for the industry average. Such method, namely comparable

company method, has less accuracy than the comparable transaction or comparable

industry transaction method (Kaplan and Ruback, 1995). Either method would give

more accurate results in estimating Murdoch’s cost of capital at market rate, since

they consider information from several – or all – companies within the industry.

The discounted cash flow method (DCF) allows more in-depth analysis in valuing a

firm. However, given the nature of Murdoch as a private business, it will be quite

difficult to find information conforming to the market’s standards, e.g. LSE-

conforming financial statement, future investment plan, a change in the

management, etc, to perform such analysis.

The maximum price of the acquisition bid

The maximum price London Globe should pay for each share of Murdoch is simply

the equity value per shares outstanding, which is £27.11/share (as seen on the table).

III. Finalising the deal

As London Globe figured out the value of Murdoch, then the next is to know for

what price the deal is going to be sealed (assuming there is no other bidder takes

part).

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The premiums paid to a privately owned business is higher than the average public-

owned ones (Ang and Kohers, 2001). Especially for cash as the method of payment,

shareholders of private firms have received premium in the amount of 2.2 times their

book value of holdings, or in other words the offer-to-book ratio is 2.2 (Ang and

Kohers, 2001). For the publicly traded target companies, Ang and Kohers find the

ratio figure as 1.9 on average.

Given that the equity value is £27.11/share, and the deal will be in cash, thus

according to the offer-to-book ratio of 2.2, the deal might be settled at £27.11 times

2.2, amounting £59.63/share. However, since the calculation has estimated the equity

value of Murdoch at the market rate, not the book value, the usage of such ratio can

be misleading. Another fact, given that the average premium paid in an acquisition

deal for a public company is about 30 to 40 percent from the market value of equity

of the target (Weston et al, 2004), this ratio may well be the most relevant in Murdoch

case. The problem is, Murdoch is a private firm. It is necessary to estimate the proper

premium ratio that reflects offer-to-market-value ratio for private firms.

As aforementioned, there are two ratios to be observed: the offer-to-book for private

firms at 2.2; and the offer-to-market for public companies at 1.35 (average between 30

and 40 percent of premium rate). Following the argument that private firms receive

more premium than the average public companies (Ang and Kohers, 2001), then the

offer-to-market for private firms, in consistency will also be higher than that of public

companies. Taking the average of both 2.2 and 1.35, the number will be at 1.8.

Consider this as the estimation of offer-to-market ratio for private firms gives the

figure of £27.11 x 1.8 = £48.79/share (£1.22 billion) as the final deal value in this

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acquisition. In theoretical sense, this means that London Globe will have to pay more

than it should. Since the synergy value has been included the valuation of Murdoch,

this excess premium will to some extent degrade the value of London Globe itself. In

reality, the case for the acquisition of private firms involves very high premiums. The

reason being is that the shareholders of private firms have stronger bargaining power

due to the very low likelihood of the agency cost problem to occur (Ang and Kohers,

2001). Or in other words, since the shareholders are actually in the management

board, which means they know exactly what the business is all about and its

prospects in the future, it requires very high premium to acquire a private firm.

IV. Eliminating competitive bidder

The first bidder (FB), which is London Globe, will have to make a bidding strategy

against the second bidder (SB) who is assumed to have valuated Murdoch and their

results on synergy ranging uniformly between -50 and 200 from FB’s valuation of the

maximum price.

The maximum price that FB has calculated is £677.77 million. The next step is to

determine at what price that FB can deter the competition from SB, i.e. determining

the pre-emptive bid. According to Fishman model (1988), we can formulate the pre-

emptive bid by using SB’s valuation range [l, h] ~ [-50, 200], the cost of acquisition by

SB, and the market value of the target.

For such purpose, the following assumptions are used:

 The market equity value of Murdoch is £677.77 million, since SB has assumed

the synergy valuation by FB as the fair equity market value of Murdoch.

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• The cost of acquiring Murdoch by SB is assumed 5% from the market value of

Murdoch.

The calculation uses the following formula (Fishman, 1988):

vo2  2vo l  h 2
p(r )   3c2
2 h  l 

Detailed process of the calculation is presented in the following table.

Variable input Calculation steps


h=200 vo2  2vol  h2
p(r )   3c2 
2 h  l 
l=-50
Vo= £677.77m £677.67 m 2  2  £677.67 m  (50)  2002
p(r )   3  £33.88m  £1, 032.35m
C2= 5%*£677.77m 2  200  50 
= £33.88m

Table 6. Pre-emptive bid by Fishman model


Pre-emptive bid value: £1,032.35m, or £41.29/share.

Bidding strategy

Fishman model (1988) provides a straightforward look at calculating the pre-emptive

bid. However, this model depends very heavily on the assumption of the cost of

acquisition by the SB. The 5% cost stated in the calculation is just an illustration, and

might be the case that it is not accurately estimated. This cost may comprise of the

investment bank fee for investigation, legal consulting fee, insider information

attainment, etc, which plays a very crucial role in determining the gain from the

acquisition deal (Fishman, 1988).

One point to look at as well is that when there is a competing bidder for an

acquisition, the bidding can turn out to be costly. Even though London Globe has

realised the amount of cash they have to generate to prevent competition, it might be

the case that Murdoch is not worth the efforts. Thus, London Globe has to formulate

a bidding strategy in order to win the bid as efficiently as possible. One way to do is

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to put the first bid at a low value. The first bid by FB is the source of valuation

signalling for the SB (Hirshleifer, 1995). SB usually determines the minimum

threshold of FB’s valuation by looking at their first bid value. From that value, SB will

begin to investigate and assume the initial bid value to compete with FB. In general,

when there is no significant gap between two bids (no far higher offer compared to

the other), the deal will be closed at relatively low price (Hirshleifer, 1995). At least,

London Globe has figured out (at 5% cost) that the pre-emptive bid will be, at the

most, £41.29/share (£1,032.35m). The bidding then can start from the initial point of

£27.11/share through £41.29/share.

V. External vs. internal equity financing

Capital Structure External financing Internal financing


Equity
London Globe2 £4,000.00m £4,000.00m
Murdoch £677.67m £677.67m
£4,677.67m £4,677.67m
Generate £50m cash £50.00m -
Total equity £4,727.67m £4,677.67m

Debt
London Globe £150.00m £150.00m
Murdoch £500.00m £500.00m
Total debt £650.00m £650.00m

Debt-equity ratio 0.137 0.138


Beta un-levered 1.21 1.21
Beta levered 1.32 1.32
Cost of equity 18.54% 18.55%
Cost of debt after tax 5.20% 5.20%
WACC 16.93% 16.92%

Table 7. Capital structure between external and internal equity financing

To finance Murdoch’s plant restructuring, or in other words pledging in a new

investment, London Globe should always consider the financing method suitable for

the feasible capital structure of the company. Table 7 presents how capital structure

will look like using two different financing strategies. The first one is the external

2
London Globe has 50 million shares outstanding at current market price of £80/share.

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equity financing and the other internal one. External equity financing involves

issuing either common stocks or warrants (Damodaran, 1997); whilst the internal one

reserves cash from the retained earnings the company has produced.

Suppose that the un-levered beta of the combined firms (between London Globe and

Murdoch) is known3, the cost of capital from both scenarios can be observed. The

figures showed do not really reflect any substantial difference between the two costs

of capital. This is because the amount of cash London Globe has to generate is

immaterial compared to the combined equity value, i.e. £50 million compared to

more than £4.5 billion.

Nonetheless, the observable point on table 7 is that the cost of capital for internal

equity financing is lower than that of external equity financing. The probable reason

for this is that the debt-to-equity ratio for the combined firm has not been the optimal

debt-to-equity ratio (Damodaran, 1997). Or in other words, the combined firm is

under-levered, because if it was over-levered, higher debt-equity would result in

higher cost of capital (Damodaran, 1997). In such condition then, it is better for

London Globe to finance the investment project with internal equity financing rather

than external one. In addition, given the fact that London Globe has been blessed by

the current booming in the housing market, there is no immediate necessity to

capitalise more in equity.

The role of asymmetric information on merger and external equity financing

3
To estimate the un-levered beta of the combined firm, the industry average un-levered beta of
building industry in Europe, specifically the residential and commercial building industry, is used. This
beta is 1.30. Taking the average between Murdoch’s un-levered beta of 1.12 and London Globe’s 1.30
gets the combined un-levered and levered beta of 1.21 and 1.32 respectively (see appendix for more
details).

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The external equity financing is a corporate capital structure policy upon an

investment opportunity. A company, from its own rational consideration may go for

this opportunity or leave it. In the case for a public company, such decision on

whether to take on the opportunity is observed by the market. The market is digging

the information about a public company’s investment policies in order to price its

stocks efficiently based on the information obtained (Myers and Majluf, 1984).

Thus, asymmetric information is a condition when the managers of the company

know something that the market does not. For example, in the case of external equity

financing let’s say a company sees an investment opportunity and need to finance it

with external equity financing. The project valuation figures show this as a

promising project to take on. The stockholders, however, are not sure about the cash

that can be generated from a further issue of stocks, since such issue might be sold at

lower price and thus lower the value of their holdings. The management board might

pull off and abandon this investment opportunity to retain the stockholder’s wealth.

The market, on the other hand, does not know about this and perceive that no new

issues of stocks as good news (asymmetric information). In fact, missing out a

profitable investment opportunity decreases the value of the company and if the

market knows this, it will bring the stock price down (Myers and Majluf, 1984). On

the contrary, if the company undertakes the external financing for this investment the

market does not know how feasible this project will be, and might reassess the level

of corporate risk, especially when the market knows that the company is undertaking

a negative NPV investment project for instance.

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From the argument of asymmetric information, it might be the case that the company

will prefer internal equity financing by rearranging its dividend payout ratio as an

alternative to external equity financing (Myers, 1984).

Furthermore, as aforementioned, in the case of London Globe and Murdoch as a

combined entity, it has under-levered circumstances, which makes its financing slack

huge enough to carry more debt (Damodaran, 1997). Thus, even if the company does

not posses enough internal resource to finance any investment, it still has the option

of optimising its leverage ratio by undertaking debt financing, as illustrated below.

Capital Structure External financing Debt financing


Equity
London Globe £4,000.00m £4,000.00m
Murdoch £677.67m £677.67m
£4,677.67m £4,677.67m
Generate £50m cash £50.00m -
Total equity £4,727.67m £4,677.67m

Debt
London Globe £150.00m £150.00m
Murdoch £500.00m £500.00m
Generate £50m cash - £20.00m
Total debt £650.00m £700.00m

Debt-equity ratio 0.137 0.149


Beta un-levered 1.21 1.21
Beta levered 1.32 1.33
Cost of equity 18.54% 18.62%
Cost of debt after tax 5.20% 5.20%
WACC 16.93% 16.87%
Table 7. Capital structure between external equity and debt financing

The weighted average cost of capital (WACC) for debt financing is lower than that of

external equity financing scenario. This proves the point that external financing,

given the asymmetric information effect, is something that any company wants to

avoid.

Let’s make the circumstances even more intriguing. If a company has little financing

slack and retained earning, which means internal equity and debt financing are out

of the question, merger will be the answer to increase value rather than issuing new

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stocks (Myers and Majluf, 1984). A merger can combine both companies’ financing

slack and internal equity, avoiding them to undertake external equity financing.

VI. Concluding remarks

The total value of Murdoch is £1,177.67 million with £677.67 (£27.11/share) of which

being the market value estimate of equity as well as the maximum price for London

Globe to pay for the acquisition. It seems though that London Globe has to spend

£1.22 billion (£48.79/share) to close the deal assuming there is no other bidder, given

the excess premium needed to acquire a private company. To prevent a competing

bidder from acquiring Murdoch, London Globe assumes the pre-emptive bid to

exceed £1.03 billion (£41.29/share).

Lastly, in choosing the method of financing the plan-restructuring, London Globe

should pursue either internal equity or debt financing given the asymmetric

information problem.

Appendix

For smaller and riskier firms


If interest coverage ratio is
greater than ≤ to Rating is Spread is
-100000 0.499999 D 20.00%
0.5 0.799999 C 12.00%
0.8 1.249999 CC 10.00%
1.25 1.499999 CCC 8.00%
1.5 1.999999 B- 6.00%
2 2.499999 B 4.00%
2.5 2.999999 B+ 3.25%
3 3.499999 BB 2.50%
3.5 3.9999999 BB+ 2.00%
4 4.499999 BBB 1.50%
4.5 5.999999 A- 1.00%
6 7.499999 A 0.85%
7.5 9.499999 A+ 0.70%
9.5 12.499999 AA 0.50%
12.5 100000 AAA 0.35%
Synthetic bond rates table using the interest coverage ratio
Based on S&P 500 bond rating classes
©2007 Aswath Damodaran, Stern Business School, New York University
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

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Industry sector Firms Beta D/E Tax U-Beta Cash/ U-Beta
Value Cash
Bldg Prod-Air&Heating 8 0.70 14.27% 25.23% 0.64 3.45% 0.66
Bldg Prod-Cement/Aggreg 32 1.08 38.41% 24.43% 0.84 4.41% 0.88
Bldg Prod-Doors&Windows 3 0.53 21.40% 24.83% 0.45 3.04% 0.47
Bldg Prod-Wood 7 1.03 35.53% 34.58% 0.84 3.79% 0.87
Bldg&Construct Prod-Misc 31 0.91 17.23% 28.40% 0.81 7.18% 0.87
Bldg-Mobil Home/Mfd Hous 6 0.67 12.27% 27.01% 0.62 11.92% 0.70
Bldg-Residential/Commer 20 1.34 11.45% 25.45% 1.24 4.79% 1.30
Average industry financial data (abridged version)
Based on European industry average
©2007 Aswath Damodaran, Stern Business School, New York University
http://www.stern.nyu.edu/~adamodar/pc/datasets/betaEurope.xls
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