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Dr. P.V. Viswanath |
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Spring 2006 |
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Notes:
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:
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:
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.
4. (8 points each) Answer the following questions in brief (no more than half a page):
1.a. Two reasons that are mentioned in the article are: one, reduction of overhead costs such as paying for audits and mailing prospectuses, and two, eliminating laggard funds make the fund family look better. Another possible reason is cross-marketing. If two fund families that offer different sorts of funds merge, this might contribute to revenue synergies. b. As far as operating synergies are concerned, it should not matter in most cases which fund is the acquiring fund and which the acquired fund, unless only part of the target fund were to be bought up by the acquiring fund. There might be some situations. For example, if one of the two funds has a better reputation, there might be a marketing advantage in having that be the surviving fund. c. A given fund family might have specific know-how in reducing tracking error when managing an index fund. It might be able to apply this technology to other funds that it might acquire. Similarly, a fund might have acquired experience in marketing to niche clienteles; it might be able to acquire the right to a specific index which another target fund has and use its experience to market that a fund based on the index to specific markets. It is not clear that this would explain the wave of mergers. Furthermore, none of these reasons as applied to the mutual fund industry have anything to do with the creation of barriers to entry. d. One reason could be increasing competition in this field, given the success of hedge funds in attracting investment even from other than wealthy investors. Increasing professionalization of the industry, which is attaining a certain maturity even in specialty funds. Ease of investment for investors and availability of information regarding different funds and their performance on the Internet. Finally, SEC regulations regarding hedge fund information disclosure and the recent scandals about special discounts given to certain investors by some funds have shone a spotlight on the industry. 2. a. In this case, E = 10, S = 8, volatility is 25%, time to maturity
is 2 years and the risk free rate is 6%. Hence, S/E = 0.80, ln(0.80) =
-0.2231; d1 = [ln(0.8) + 2(0.06+0.5s2)]/ b. The patent, itself, might be a real option if the products using the
technology have not been developed. Thus, one would have to evaluate the
revenues from the possible products that might come out of having the
patented technology. We would then apply the real option model to derive
the price. Of course, in order to do this, we would need other inputs,
such as the value today of a project using the technology using the patent
technology. c. If the exercise price were $8 million, then the present value of the exercise price would be lower as well. Of course, d2would be lower as well. But we could estimate it with our current values; this would give us a price of 3.6336 - (8/10)(2.8381) = 1.363. In any case, we know that the value of the option would be higher. d. It depends on what the product is, that underlies the patent. If it's already developed, then it would be easier to come up with a volatility for that product, using data on the market values for the project producing and selling that product. The volatility of the patent could then be estimated by first estimating the hedge ratio of this option, which is inherent in the patent and then grossing up the volatility using this hedge ratio. 3. a.
FCFE for 2004 is $3.011 million. (If you used 1372 instead of -1372, you would get $0.267 m.) This assumes that all of the new investment comes from equity. However, another possibility is to use the information relating to the debt-equity ratio from part (c). Then, the formula for FCFE = Net Income - (1-d )(Capital Expenditures - Depreciation) - (1-d )D Non-cash Working Capital, where d is the target debt ratio. The target debt ratio, assuming that the target debt-equity ratio is the current one of 0.758 is (0.758/1.758), or 0.4312; (1-d ) = 0.5688. We obtain, for 2004, FCFE = 1763 - 0.5688(1767-1643) - 0.5688(-1372) = 2472.86 in thousands or $2.473 million. The FCFE is lower in this case because in order to keep the debt ratio the same, the firm has to buy back some debt or swap it for equity. The following questions can of course be solved using this approach, as well. However, I have not provided a solution based on this alternative approach. b. The required rate of return using a market risk premium of 5.5% is 4 + 1.4(5.5) = 11.7%. If you used $3.011 as the FCFE for 2004, the answer is 3.011(1.08)2/(.117 - 0.08) = $94.92 million. Keep in mind that the last date for which FCFE data is available is July 31, 2004. If today is July 31, 2005, we need to estimate FCFE for the year ended July 31, 2005; this can be estimated by taking 3011 and multiplying by 1.08. (If you used $0.267 as your FCFE number for 2004, your answer would be 94.92(0.267/3.011) = 8.417m. c. The unlevered beta = levered beta /[1+(D/E)(1-t)] = 1.4/(1+(0.758)(0.6)) = 0.9623 4. a. (See p. 79 of Bruner) The main reasons according to him were to correct agency problems and governance problems. This hypothesis is supported by the fact that many of these takeovers involved taking on a lot of debt. A lot of debt reduces free cash flow and consequently agency problems. Also, if the mergers were due to synergies, they should not have been hostile. b. It's not clear from that paragraph what a logical reason for a merger might be. Perhaps it's to reduce operating costs. The seeming reason from the paragraph is to create seeming growth through a merger; however, such growth is only illusory. Another possible reason, though not supported by the context of the paragraph is to create a national market, since the geographical coverage of the two companies do not overlap; it's not clear, though, why this is an advantage. (One student wrote that they would be able to obtain economies of scale by combining back-office operations; one, it's not clear how this might happen, and two, that doesn't seem to be the implication of the paragraph, either. But I wouldn't rule it out of hand...) c. Traditionally, the acquirer's stock drops, while the target's stock price rise. This has happened here, as well. One of the usual reasons given is that the acquirer has overpaid due to hubris. Another reason might be that the acquisition was done through stock and this was seen as a signal that AT&T stock is overvalued. d. It would seem to be a horizontal merger; the simplest explanation for a horizontal merger of likes would be operating synergies. e. It doesn't look like a real option, simply a business opportunity. For it to be a real option, the optimality of the acquisition has to be contingent on some other random event. Notes:
Here are three articles from the BBC website. The first one is from April 13, the second from April 28, and the third from May 4, 2006. Read the articles carefully and answer the questions that follow: Mitchells & Butlers spurns offer The pub group behind the All Bar One and Harvester chains has rejected
an informal £2.7bn takeover approach from a private equity consortium.
Formal offer M&B confirms Beefeater interest Pub and restaurant chain Mitchells & Butlers has confirmed reports
it is considering buying 250 Beefeater and Brewers Fayre outlets from
Whitbread. Debt increase? Pub group M&B snubs bid approach Pub and restaurant group Mitchells & Butlers has rejected a £2.7bn ($4.97bn) takeover approach from a consortium led by tycoon Robert Tchenguiz. M&B, which owns the Harvester and All Bar One chains, said the offer undervalued the business. The group operates about 2,000 outlets across the UK. M&B emerged as a potential bid target for Mr Tchenguiz in March, and the Takeover Panel had given him until 8 May to make a formal bid or walk away. Bid defence However, setting out its reasons for rejecting the approach, M&B said its like-for-like sales - a measure which strips out the impact of new outlets - had grown at the fastest rate in the sector over the past two years. It added that sales had risen by 4.1% in the first 29 weeks of the current financial year. "The board believes that the company has excellent prospects for organic growth and is well placed to take advantage of further consolidation opportunities," the company said. Questions:
4. (20 points) Suppose MAB believes that demand for beer worldwide will be rising over the next year, and, as such, it demands a higher price for its shares. R2O does not believe that this is so. If this is the main source of disagreement between MAB’s management and R2O, how can they come to an agreement? 5. (20 points) Read the following article from the Economist of April
6, 2006 and answer the following question: Once more unto the breach, dear clients, once
more The pace of dealmaking in the first quarter of 2006 was feverish. Globally, the value of M&A averaged $10 billion a day, the highest for six years (in other words, since the height of the dotcom frenzy). This time, Europe accounted for more activity than America. According to Dealogic, a data provider, purchases of European companies added up to $418 billion, the most ever in a first quarter and more than twice as much as at the start of 2005. In America the total was $311 billion, up by 5% on a strong quarter last year. Globally, the deals were big and brass-knuckled: led by AT&T's $67 billion acquisition of BellSouth, 14 were worth more than $10 billion; and many more bids were hostile than in the recent past. But in contrast to the last merger boom, deals were far more likely to be financed by cash than by shares. Two-thirds of all M&A in the quarter was cash only. It is partly this use of cash that encourages bankers to claim, as they so often have in the past, that this time is different—that these transactions will not end up destroying value for everyone (or almost everyone: the bankers themselves always seem to come out ahead). Cash, indeed, is abundant, debt is cheap and equity markets so far have applauded many mergers, so the bankers have half a point. But it is human, as much as financial, frailty that has undermined many deals in the past—and it may be only a matter of time before once again, fear and greed trip corporate chiefs into a new cycle of excess. For now, however, the financial underpinnings of the takeover boom appear more solid than at comparable times in the late 1980s and late 1990s. Companies in America and Europe have been through a long period of cost-cutting and balance-sheet repair since the dotcom boom ended. This has helped generate bumper profits and cash, which shareholders have decided they can trust companies to spend wisely—through either capital expenditure or acquisitions. “In the last 18 months, the equity markets have done a 180-degree flip,” says Anthony Burgess, head of European M&A at Deutsche Bank. “They've become very positive about giving management the licence to do M&A.” By way of illustration, consider how stockmarkets have taken the rare step of rewarding predators for their bravery, as well as pushing up the share prices of their prey. Frank Yeary, global head of M&A at Citigroup, notes that the share prices of companies in the S&P 500 that have recently launched takeover bids worth $1 billion or more have outperformed the market in the 90 days after deals are announced. One reason for this unusual performance, he believes, is that takeover premiums have been modest. The difference between an offer price and the target company's previous share price is averaging around 20%, compared with 35-40% at past peaks of merger activity, he says. “It's a good environment to do deals.” Another reason for encouragement from shareholders is the cheap, plentiful debt that companies are, for the moment, able to use for deals, thereby lowering the cost of capital and increasing earnings per share. Although bankers are reluctant to say that there is a credit bubble, there are certainly signs of one. For a start, it is easy to raise money even if the leverage cuts a borrower's credit rating. Credit quality is thus starting to slip. For example, Standard & Poor's, a rating agency, notes that the number of AA-rated (ie, very creditworthy) issuers has slid from 39 to 23 since 2001, while the number of much riskier BB credits has doubled. Listed acquirers are having to dig deeper to compete against private-equity rivals flush with debt. Already, there are signs that the listed buyers are starting to gain the upper hand, as they should with the cost savings they can expect to make. According to Dealogic, the value of private-equity-backed M&A shrank to 14% of the total in the quarter just completed, compared with more than 25% in 2004. Companies are being told that they have too little debt on their balance sheets. Last month analysts at Goldman Sachs estimated that European companies alone could draw upon €630 billion of funds, partly by raising their ratio of net debt to equity to the long-run average of 43%. That is equivalent to more than 8% of the value of Europe's stockmarkets. Companies that might otherwise balk at taking on more debt are being told by silver-tongued bankers that there are good reasons to do so. One such was Linde, the German chemicals company which made an agreed €11.6 billion takeover of Britain's BOC that will, if not blocked on antitrust grounds, create one of the world's top industrial-gas companies. The takeover will enable it to remove overlapping costs, and its increased size may also give it pricing power. Bankers say such “horizontal integration” is a prime reason why dealmaking is busier in Europe than in America. In the United States, industries such as telecommunications and defence have already been consolidated and now contain only a few enormous companies. In Europe, only now is cross-border integration happening with the zeal that had been expected at the birth of the euro. For the moment, the bulk of cross-border activity in Europe has been in utilities and energy, two industries that have raised the hackles of protectionist politicians, especially when the bidders come from abroad. In a few instances activist shareholders, too, have voiced opposition to transactions. VNU, a Dutch business-information group, is facing its second shareholder rebellion in less than six months. But generally, as long as deals look as if they will create industrial powerhouses, cost synergies or pricing power, the markets are still supportive. They will stay that way until money gets tighter, profits ebb or managers lose their heads. The trouble is that, on past form, it wouldn't be surprising if all those things happened at once. 1.We can conceive of different classes of strategies -- one, strategies
that decrease the perception of intrinsic value of target to attacker;
two, increase the price paid by attacker; three, increase transactions
costs of attacker by defensive litigation and defensive appeals to regulators. 2. R2O is offering cash, which is quite suitable for a hostile acquisition, which is what this is developing to be. Clearly, R2O realized this even when it made its initial informal bid. With cash, the target shareholders will be more likely to accept the bid, since there is no uncertainty of the value of the bid. The cash tender offer could probably also be prosecuted much more quickly, thus giving M&B less time to find a white knight. 3. a. The initial offer was made Thursday, April 13th. Prices after April
13th would, obviously, be affected by the market's evaluation of the likelihood
of success of the acquisition. Hence the date to use to perform a bargaining
range analysis would have to be based on prices as of April 12th, 2006. 4. The payments for MAB could be structured to be increasing in the price of beer. For example, the price could be 550p +1.5(Price of beer in 1 year - Current price of beer). In addition, if MAB shareholders wanted a floor, the pricing structure could be something like 550p +Max[0,1.5(Price of beer in 1 year - Current price of beer]. In this way, if the price of beer were to rise, MAB shareholders would get a higher price; if not, they would get exactly 550p. It is important to note that the disagreement is about something objective and external to the firm; hence it makes sense to use an outside standard, such as the price of beer (or worldwide beer consumption), rather than a standard earnout. 5. There are two different profiles of targets of hostile takeovers -- one theory holds that targets are inefficiently run firms; the other theory holds that targets represent attractive investment opportunities for the prospective acquirer. The article actually focuses on the easy availability of cash, either directly from acquirer balance sheets or indirectly through the issue of more debt as the reason for the spate of hostile takeovers. However, some pointers as to which of the two theories are operative can be gleaned from the article. For example, it is likely that targets are as underleveraged as acquirers -- this, in a sense, is inefficient financial management. Similarly, if acquirers are flush with cash, targets probably are also flush with cash -- if so, they might not be using the available cash as efficiently. On the other hand, the last line notes: "..as long as deals look as if they will create industrial powerhouses, cost synergies or pricing power, the markets are still supportive." This suggests that the motivation for the mergers is the existence of cost and revenue synergies, which says less about the inefficiency of target management than about profitable investment opportunities for the acquirer. However, there must be some element of resistance by target management to the unlocking of this value, else there would be no need for a hostile takeover.
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and d2 = d1 - 