Case 5: Merger Analysis

Computer concepts/computech

Louis De Moffarts
Vincent Lopez

6049563
6046258

Clarissa Hauptmann

1. Synergies arise when the sum of the combined companies is greater than the individual part
of each firm. This process can be considered as the main aspect as why companies engage in
merger since, they can benefit from economies of scale in its operations, from lower
transaction cost due to the financial economies and to a reduction in tax. In addition, it will
increase the market shares, and thus, it should in theory provide them with a higher benefit
due to less competition. However, many agencies consider monopolistic market as a threat
and might impose them to charge higher prices. With regard to the society, the synergistic gain
benefit everyone in the society due to a larger share of the pie (2+2=5 effect) and is
probably the most crucial in this context. Some companies may lack investment opportunities,
but when they do, they can decide to spend their excess of cash into the purchase of another
firm in order to minimize their taxes. The tax consideration for a large company which lies in
the high tax bracket could in theory take advantage of the tax shield, and create extra value for
the stockholders. Furthermore, the difference between the book value and purchase price can
be depreciate annually, which can reduce the tax payable. However, the tax savings from this
transaction are relatively lower than the premium paid for the merger, which will ultimately
result in a reduction of shareholders wealth and to the society as a whole. The control
rationale is based on the concept of empire building of the managers who wants to control
bigger companies for their ego, pride but also for the salary. This rationale has no
consideration for the society and does not create value for the firm since most of the
acquisitions are unnecessary. Mergers that are only motivated by diversification may result in
the destruction of the companys value. Many studies have proven the fact that diversified
companies are significantly less valuable than initially. Another factor influencing merger is
the purchase of assets below their replacement cost. The acquirer company can fully benefit
from this transaction, since it is still in operation and simply requires maintenance to keep the
asset operational. This process will have a negative impact on the society, since the companies
who pursue this strategy will most certainly sell it for a profit.
2.In a friendly takeover, the target and the acquiring company negotiate together to establish a
fair price for the merger. The management team of the target company recommends to their
shareholders to accept the offer because the acquiring company is giving them a fair price in
exchange of their stocks. However, hostile takeovers do not work in the same way. The
acquirer directly makes a proposition to the shareholders of the target company without
having any arrangements with their management team. Then the target companys
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management team advises their stockholders not to accept the proposition because the price
offered is to low or because they do not want to be taken over by another company. In order to
counter the actions taken by the target companys management team, the acquiring company
often increases their bid by adding a considerable premium above the previous proposition.
As a result of the increase in price, usually shareholders tend to accept the offer and sell their
shares.
3. The calculations of CCIs cash flow statements can be found in Appendix figure 1. Usually,
interest expenses are accounted when using the WACC. However, when analysing mergers,
interest expenses may fluctuate because of the change in debt through the different stages of
the merger. Interest expenses are tax deductible, consequently it is more accurate to deduct it
into the cash flow statement and to use the APV to calculate the tax shield separately.
Furthermore Retained earnings are deducted because they are needed to finance the growth of
the targeted company. This money is not available to shareholders and hence reduces the
value of the targeted firm.
4. Because of the variations in capital structure due to the merger, the adjusted present value
(APV) method should be used. Indeed, when the capital structure of a company changes, this
method is more flexible because it allows calculating the free cash flows by using the
unlevered value of the firm and the value of the tax shield discounted at the unlevered cost of
capital. We used Hamadas equation to calculate the unlevered beta of 1,485. Afterwards, as
we calculated in Appendix figure 2, we relevered the beta and obtain a levered beta of 1,782
because of the new capital structure due to the merger. We could then plug it into the CAPM
formula to obtain a post merger levered cost of equity of 15,41% and an unlevered cost of
equity of 13,6 %. An error in the discount rate would have an effect on the maximum offer
price since it would change the present equity value of the firm and similarly the share price.
To see the exact effect of a change in the discount rate on those values, we advise to further
conduct a sensitivity analysis.

5. The terminal value of CCI is $21.3679.25 and the horizon value of the tax shield is
609.775,74$. The value of CCI to CompuTech in the beginning of 1996 can be found by
calculating the Present Value of the incremental cash flows. We estimate the value of CCI to
Computech in 1996 to be $16.402.812 by discounting all the cash flows to the year 1996.

Since other companies would not have the same synergies with CCI, they would value the
synergy gains differently. Therefore they would calculate different cash flows and the value of
CCI to their firm would be different as well.
6a. There is a large selection of possible tactics available to keep the firm safe from any
acquisition. A firm could simply change her bylaws in order to increase the percentage needed
in order to achieve consensus regarding the merger (up to 80%). In addition, a company can
have a staggered board, which would limit the number of new directors elected each year.
This implies that in case of a merger, only one third of the directors would be dismissed,
meaning the acquirer will only have a small share of the seats in the board of directors.
Furthermore, the firm can raise antitrust issues to slower the operation due to the intervention
of the Federal Trade Commission and the Justice Department. A simple method to increase the
acquisition is to repurchase stock in the open market hoping to increase the stock price, and
make the acquisition more expensive. Additionally, the firm can use white knights or white
squire. The first one refers to a friendly company that agreed to exceed the initial offer, and
merge. The white squire is also friendly, and consists of buying a large share of the target
company to avoid any possible acquirer. Finally, numerous poison pills h can be used against
the threat of a takeover, such as short-term loans, stock purchase right, which gives the
stockholders the right to repurchase shares for half of its value, or providing expensive golden
parachutes to the management team.
6b. CCI should make use of a white knight, since it can compete against the other acquirer
and raise the current bid. In addition, the white knight is more suitable than using a poison pill
since it does not destroy the value of the firm, it simply raises the competition and hence the
price. It is important to mention here, that this method should be used to raise the price of the
bid and not to fight for keeping the company. Finally, some studies have shown that investing
in divestitures affects positively the stock market and increase the price of the stock on the
announcement date.
6c. In order to determine the true value of the company, it is important to hire an investment
bank. This can be done for a friendly merger as well as for a hostile takeover since it can
benefit both parties. The acquirer will desire to buy the target company for the lowest price
possible, while the target company will want to claim that the price offered is lower than what
it should be.
6d. We can easily assure that the management team does face potential conflicts of interest. In
most successful cases of takeover, the management team is fired, however it is mentioned in
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the case, that managers are willing to keep their actual position. If the acquirer is ready to
offer important compensation and job opportunities, this will have an impact on the managers
and they might be tempted to sell their share for a lower price. However, managers own
shares in the target company and it would be more profitable for them to achieve a higher
share price prior to the takeover. Additionally, managers could purchase all types of perks just
before the takeover to decrease the overall value for the acquirer.
7. Based on the calculations in Appendix figure 3, Computer tech could pay a premium of
$3,87 per share (258% premium) to buy back the shares of CCI owing to the projected
synergies created by the Merger. A bid close to $1,5 would benefit more ComputerTechs
shareholders while a bid close to 5,37$ would benefit CCIs shareholders. Both companies
should help them with investment bankers to find a fair price for the stock. ComputerTech
should not offer a too low initial price otherwise it would seems to be a bad deal for the
targeted companys shareholders, which could turn the deal into a hostile takeover.
8. Many empirical studies have demonstrated that mergers and acquisitions increase the
wealth of the shareholders of the target firm. However, it is not so certain concerning the
wealth of the shareholders of the acquirer firm. Some particular managers may not be seeking
to maximize the wealth but rather to expand their empire and seek to receive higher wages
due to the increasing size of their company. In order to accurately measure the benefit of a
merger, we can look at the abnormal returns during the merger. From this study, we can
conclude that on average the stock price of target firms increase by 30% in an hostile
takeover, while it increase by only 20% during a friendly merger. On the other hand, the stock
price of the acquirer remains constant. As a conclusion, mergers do create value but the
shareholders of the target firm derive all the benefits.
9. A sensitivity analysis provides relevant information about how a change in the variable cost
would impact the firm value keeping other factors constant. On the one hand, an increase in
the variable cost ratio would decrease the firm value and consequently the share price and on
the other hand, a decrease in the ratio would increase the value of the firm and the share price.
In the appendix, figure 4 provides a sensitivity analysis that shows the effect of variable cost
ratio on the share price. We can see that at 85,8%, the share price declines to $3,5.

10. The projected return on equity can be calculated by dividing the projected Net income by
the value of equity. As it can be seen in Appendix figure 5, we obtained a relatively high
projected ROE of 38,8% for 1999. On the one hand, this could be due to overly positive
assumptions like the projected 20% sales growth. On the other hand, the project could create
good synergies and be extremely profitable for shareholders.
11. If the company decide to pay in cash, shareholders will have to pay capital gain taxes and
we know that the preference of the investors is to defer the tax payment. However if the
premium offered for the stock is significantly important, they might consider maximizing
their present value. On the other side, if shareholders receive stocks, they will have more
flexibility and could realize their gains when they want to and benefit from this non-taxable
transaction. The taxation process regarding the merger can be tricky since the acquirer and the
target firm will also influence the preferences in function of their main purpose.
12. In order to acquire the CCI, the management team of ComputerTech should make an offer
ranging from $1.5 to $5.37. The optimal price offered should lie on the upper boundary of
this range, since it would imply that you are ready to engage in a friendly merger. In addition,
offering it can be helpful to intimidate other potential acquirers. On the contrary, a price on
the lower end of the range would imply an unsuccessful attempt to takeover the firm. Due to
the excess cash, it would be interesting for CompuTech to purchase the target firm with their
cash reserve in order to benefit from the tax effect. Nevertheless, from a shareholder
perspective, it would be more suitable to pay with stocks since shareholders prefer the
taxation on stocks.

Appendix
Figure 1: Question 3, 5

Figure 2: Question 4

bu =

1.6

=1.485
0,1
)
0,9
0,25
bl =1,485 1+ ( 10,4 )
=1,782 .
0,75
1+ ( 10,3 )(

( ))

r s =6,5 +5 1,782=15,41 %
r su=0,3310 + ( 10,33 )15,41 =13,6

Figure 3: Question 7

Figure 4 : Question 9

Figure 5: Question 10

ROE=

Net income
AssetsLiability
ROE=

$ 1.528 .115
=
($ 5.247 .019$ 1.311 .755)

38,83 %