LUBIN SCHOOL OF BUSINESS
Pace University
Fin 648 Mergers and Acquisitions
Prof. P.V. Viswanath
Spring 2006
Midterm

Notes:

  1. If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  2. If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  3. You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
  4. You must explain all your answers. Answers without explanations may get no points or be heavily penalized.

1. Read the following excerpt from the article, "Mutual-Fund Mergers Jump Sharply" by Eleanor Laise from the New York Times of March 9, 2006 and answer the questions below:

  1. (10 points) Name two motivations for such mergers that you can find in the article. Name one other motivation that is not mentioned in the article.
  2. (10 points) If you were a financial executive in a fund family and you had decided to merge two funds in order to realize operating synergies, how would you decide which fund would be the acquiring fund, and which the acquired fund?
  3. (5 points) Porter notes that barriers to entry can make it more difficult for new entrants into an industry. Here are four ways in which such barriers might be created.
    1. Regulatory restrictions (e.g. banking license),
    2. brand names (e.g. Xerox, McDonalds – can develop customer loyalty; hard to develop and/or imitate)
      patents (illegal to exploit without ownership; e.g. new drugs – cf. also RIM)
    3. and unique know-how (e.g. WalMart’s “hot docking” technique of logistics management)
    4. Accumulated experience (cf. learning curve)
    Which, if any, of these might explain the wave of mergers in the mutual fund industry?
  4. (10 points) What might be the reason for the sharp rise in mergers in this industry at this time?

Combinations Can Cut Costs for Investors, But May Create Investment-Mix, Tax Problems

A growing number of mutual funds are merging as financial-services companies come under pressure to cut costs, but fund investors don't always come out winners.

Last year, 222 mutual funds were absorbed into other funds, a 66% jump from a year earlier, and the highest number since 2001, when fund companies eliminated more than 530 funds through mergers in the wake of the dot-com crash, according to investment-research firm Morningstar Inc. The trend is expected to continue as major Wall Street firms increasingly exit the competitive mutual-fund business, including last month's agreement by Merrill Lynch & Co. to sell its investment-management business to money manager BlackRock Inc. Independent fund companies also are consolidating more funds as they grapple with stiffer regulations and growing competition from other investment products.

Fund companies say mergers create economies of scale and allow them to trim certain overhead costs such as paying for audits and mailing prospectuses. Last year, Bank of America Corp.'s Columbia Management unit combined its Tax Managed Growth Fund I, which had an expense ratio of 1.31%, with its Tax Managed Growth Fund II, with expenses of 1.49%, to create a combined fund with a lower expense ratio of 1.22%.

There is another motivation for the mergers. Some mergers eliminate laggard funds, allowing a fund family to put a better face on its overall performance. RiverSource Investments, a unit of Ameriprise Financial Inc., plans to merge its $8.2 billion New Dimensions fund, whose returns fell near the bottom of its large-growth category over the past one and three years, into its $1.4 billion Large Cap Equity fund. The latter fund also has a poor three-year record, but ranked in the top half of its category over the past year, according to Morningstar. An Ameriprise spokesman says the combined fund will be managed using the strategy of the more successful Large Cap Equity fund.

While fund companies often benefit from combining funds, investors need to be wary. Fund mergers can depress the performance of an acquiring fund, while bestowing most of the merger's benefits, including lower fees and better returns, on the acquired fund's shareholders. Mergers that join funds with dissimilar strategies also can hit investors with higher taxes, and throw off shareholders' investment objectives.

When funds merge, "some red flags should go up immediately," says Phil Edwards, managing director of investment services at Standard & Poor's.

Mergers often need approval from shareholders, who have generally been willing to go along with the moves. But only shareholders of a fund being acquired get to vote on a deal, not the holders of an acquiring fund. There are no hard and fast rules that determine which fund is to be the acquiring fund in a merger, says a Securities and Exchange Commission official. The SEC has oversight powers to intercede in a merger.

Mergers also must be approved by the funds' boards. The Independent Directors Council, an arm of the mutual-fund trade group Investment Company Institute, is expected to deliver recommendations this spring on what issues directors should consider, including fund fees and performance, in approving mergers.

In a move that will bring higher expenses, TIAA-CREF plans to merge five stock mutual funds for individual investors into several of its institutional funds, which recently won shareholder approval for fee increases. The company will make available a special class of shares in its institutional funds for the individual investors. A TIAA-CREF spokeswoman says the company's funds "had been priced too low and had been losing money."

2. Your company is considering acquiring a patent for an innovative hard drive from a computer hardware company. The seller agrees to give you the right to purchase the patent after two years for $10 million. Based on market research data, the estimate value of the patent today is $8 million. But uncertainty about the patent's success leads you to conclude that its value has a future volatility of 25 percent. If the two-year risk free rate is 6% per annum, answer the following questions:

  1. (8 points) What is the value of this right? You can use the following information:
    N(-0.115) = 0.454, N(-0.469) = 0.32, N(0.115) = 0.546, N(0.469) = 0.68, N(-0.223) = 0.412, N(0.223) = 0.588
    The Black-Scholes formula gives the value, C, of a call option with exercise price E and expiring in t years, written on an asset with variance of the continuous return equal to s2 per year and currently selling at S. (This formula assumes that there is continuous trading, and that the option can only be exercised at maturity):
    C = S N(d1) - E e-rt N(d2); and d2 = d1 -
    N(.) is the area under the standardized normal curve (i.e. the plot of probability against value for a normally distributed variable with mean zero and s.d. = 1).
  2. (5 points) If you weren't given the probable price of the patent today, how might you go about estimating it?
  3. (7 points) If the exercise price were $8 million, instead of $10m., would the value of the right to buy the patent be greater or less? Estimate by how much.
  4. (5 points) How might you go about estimating the volatility regarding the future value of the patent?

3. KMG Chemicals (Nasdaq: KMGB) reported Net Income of 1763, 1917 and 2685 for the financial years ending July 31 for 2004, 2003 and 2002 respectively (all numbers in thousands, unless otherwise stated). Capital Expenditures for the three years were $1,767; $276; and $1,361. Depreciation was $1,643; $1,423; and $1,391. Change in Non-Cash Working Capital for 2003 and 2004 were $549 and -$1,372.

  1. (5 points) What was the FCFE in 2004?
  2. (10 points) Assuming a growth rate in FCFE of 8% forever, what is your estimate of the price per share for KMG? For the purpose of this computation, assume that today's date is July 31, 2005. Assume a stock beta of 1.4 for KMG, a risk free rate of 4% and reasonable values for any other quantities that you need for your computation (justify any assumptions).
  3. (10 points) If KMG's debt-equity ratio is 0.758, according to Yahoo Finance, today, March 9, 2006. If its stock beta were 1.4 and its marginal tax rate were 40%, what would its asset beta be?

4. (8 points each) Answer the following questions in brief (no more than half a page):

  1. M&A activity in the 1980s had relatively high volumes of hostile takeovers and leveraged buyouts. What problems do you think these acquisitions were looking to correct?
  2. The article "The Breakdown of 'Breakup" in the March 9, 2006 WSJ contains the following sentences:
    AT&T and BellSouth offer conventional telephone service in different regions of the country. AT&T (formerly called "Southwestern Bell") operates in the Southwest, Far West and the Midwest. BellSouth provides telephone service in the Southeast. Both companies are losing subscriber lines rather rapidly as consumers switch to cellular phones or "voice over Internet protocol" (VOIP) provided by the cable companies or independent providers, such as Vonage. The new broadband (DSL) Internet services offered by these erstwhile phone titans have not been sufficient to offset the revenue losses from traditional telephone services.
    According to this, what is the rationale for the AT&T/BellSouth merger?
  3. The March 8, 2006 WSJ has this to say about the AT&T/ BellSouth merger: "So far the deal has unfolded in textbook fashion: AT&T dropped about 3.5% on the news to $27.02 on Monday. BellSouth shares jumped 10% to $34.50, approaching the offering price of about $37." Explain why this might have happened.
  4. The March 6, 2006 WSJ in an article entitled "TNT Still Seen as Takeover Target" starts out with the following sentence:
    Despite its position as the No. 1 operator in the European express market and the world's second-largest logistics provider, the recent boom in the logistics sector hasn't shaken speculation that former Dutch mail monopoly TNT is a potential takeover target.
    The article mentions FedEx and United Parcel Service Inc. as possible suitors. Would these be vertical or horizontal mergers? What might the rationale be for such a merger?
  5. The same article comments on TNT's strategy:

    "We have no plans to make big acquisitions. But, for example, the acquisition of a freight-management company in China is an interesting option," Mr. Bakker said.

    He wants TNT to become the market leader of the pan-European postal market as it deregulates. However, the company's mail unit, TNT Mail, which accounted for around 38% of group revenue in 2005, has to deal with electronic mail and increased competition. That partially explains why TNT's margins fell to 19.5% last year and are expected to decline further to 18% this year.

    By using its complementary mail and express networks and simplifying its organizational structure, TNT can further reduce costs, Mr. Bakker said. "We can benefit from synergies between mail and express by using the hubs and our road network. Also, management can be used for both businesses as the economy of the delivery business is more or less the same. For example, linking the road network we have in Southeast Asia with our China operations should make us a leader in the express business in China within five years," Mr. Bakker said.

    Would you describe the Chinese freight-management company acquisition as a real option? Explain why or why not.