THE UNIVERSITY OF NORTH CAROLINA AT GREENSBORO Joseph M. Bryan School of Business and Economics Master of Business Administration Program

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1 THE UNIVERSITY OF NORTH CAROLINA AT GREENSBORO Joseph M. Bryan School of Business and Economics Master of Business Administration Program MERGERS AND ACQUISITIONS MBA Spring 2006 Professors John Englar/Sheldon Balbirer Office Hours: By Appointment Office: 369 Bryan Building (336) (Office) (919) (Home) (336) (Fax) Required Texts: Case Packet Available in the Bookstore. Purpose: MBA 683 is designed to provide students with an understanding of the motives and consequences of corporate mergers and acquisitions. Upon completion of this course, students should be equipped to: 1. Identify the different ways businesses can be acquired and indicate the circumstances under which each might be appropriate. 2. Assess a merger/acquisition in terms of it meeting a firm s strategic objectives. 3. Evaluate a merger s synergies and how it might impact the organizational structure of both the target and acquiring firm. 4. Value a merger/acquisition from an economic perspective. Use this information to structure a merger deal. Course Requirements: A student s final grade will be based on two case write-ups, class participation and a term paper. The relative weight of each component is as follows: Case Write-up #1 20% Case Write-up #2 20% Class Participation 20% Term Paper 40% Write-ups may be prepared on any two of the following cases; MRC (A), Cooper Industries, Yeats Valve and Controls, Brown-Forman Distillers Corporation, Sybron Corporation, Eskimo Pie Corporation, Anheuser-Busch and Campbell Taggart, the John Case Company, and Philip Morris Company and Kraft, Inc. To insure that you deal with a range of issues over the course of the semester, at least one case must be turned in during the first four weeks of the semester. Write-ups should be individual efforts and are to be turned in on the evening of class discussion. Typically, a write-up should be no more than six typed pages, exclusive of exhibits. Each case write-up should contain (at a minimum) some discussion of (1) the degree

2 to which the proposed target serves the acquiring firm s strategic objectives, and (2) any valuation issues that appear to be relevant in the setting of the merger/acquisition terms. Class participation is an important and will count for 20 percent of your final grade. Beyond the day-to-day participation, you may be asked to present one of your case write-ups, and you will make a presentation at the end of the course discussing your merger analysis project described below. Finally, students will be asked to complete a term paper on any merger listed in the project description at the end of the syllabus. The paper should be no longer than 25 pages exclusive of exhibits. The paper is due on April 26 th so that it is a good idea to begin the research as soon as possible. You must identify your choice of transaction by class on March 22 nd. A few final notes: First, beyond the cases, there is no required text for the class. Instead, Professor Balbirer has put together a lengthy handout dealing with the strategic and valuation aspects of mergers and acquisitions. This will be distributed during the first day of class. Students who wish to get a copy sooner, can simply Professor Balbirer and he will send you an electronic. If you are uncomfortable without a text, he can suggest a few $130 comprehensive texts on the subject that you can buy. Second, MBA 621 (Strategy Formulation) and MBA 625 (Creating Value Through Financial Policy) are prerequisites for this course. Unless you have had these courses or their equivalent, taking MBA 683 will be as much fun as chewing on a razorblade. SESSION ASSIGNMENTS Session 1, March 15 th We ll use this class period to accomplish two things; first, Professor Englar will lead a discussion on paths to corporate growth and the choices managers face. After discussing the role of acquisitions in this strategic thought process, we will devote the rest of the course to this option. We begin review in detail the techniques dealing with the valuation of entities using the Kennecott Copper case. This case was used in MBA 625. Those students who have not had MBA 625 but some equivalent course can find a copy of the Kennecott case in the instructor s mailbox outside of room 369 in the Bryan Building. As you prepare the case, consider the following questions: 1. What potential economies or synergies are associated with the merger? How does it rate on considerations such as strategic fit? 2

3 2. Critically evaluate the methodology employed in the case to value the proposed acquisition of Carborundum by Kennecott. As part of analysis, review case Exhibit 7 carefully. Are the cash flows at the bottom of the exhibit free cash flows, or cash flows to equity? What rate are they being discounted at? What rate should they be discounted at? How should Kennecott s proposed change in the capital structure of Carborundum influence the analysis? Note: To answer this question, it is essential that you calculate the risk-adjusted required return for Carborundum using the pure-play technique. 3. Is Carborundum worth $66 a share to Kennecott? If not, how much is it worth? As an outside director, how would you vote on the resolution to acquire Carborundum? 4. Review management s decisions over the ten years of the case. Were the best interests of the stockholders served by these decisions? 5. Critically evaluate the motivation, performance, and role played by Kennecott s board of directors, and its outside legal and investment banking expert advisors throughout the period covered in the case. Those students who wish to refresh their background on the valuation of entities should read Section 4 in the monograph. Session 2, March 22 nd In this session, we will take up the MRC (A) case with an eye towards broadening the range of tools for evaluating an acquisition in strategic and economic terms. The analytical aspects of the case are relatively straightforward; however, there are some very interesting strategic dimensions, which will require your attention. As you prepare the case, consider the following questions: 1. What are the key elements of MRC s corporate strategy? 2. Would MRC s strategic interests be advanced by the acquisition of ARI? If so, how? 3. Assume MRC acquires ARI for $40 million and liquidates the firm in What rate of return would it receive on its investment? Sufficient data is available in the case text and exhibits to calculate the project s IRR. Don t ignore the cash inflows associated with the reductions in working capital over time as sales decline. 4. What are the downside risks of the ARI acquisition? To assess this issue, suppose ARI acquires ARI for $40 million and liquidates the firm immediately. Estimate the cash proceeds from such a move. In arriving at your estimates, do not ignore the tax benefits associated with the write-off or sale of assets at less than their book value. 5. What problems would you expect to encounter in managing ARI in the future? 3

4 6. The appendix to the case provides details of MRC s capital budgeting practices. In general, what do you think of them? Do they seem to be well suited to handle a project like the ARI acquisition? 7. If MRC acquires MRI, should it account for the transaction using a pooling-of-interest, or the purchase accounting method? If you are unfamiliar with the accounting for mergers, Section 7 in the handout provides the basics. 8. Should MRC go ahead with the acquisition of ARI at an asking price of $40 million? Session 3, March 29 th In this class, we ll first take up the Cooper Industries case. As Harvard cases go, Cooper Industries is a classic having sold more copies than any other case written in the mergers and acquisitions field. It is an example of an acquisition via tender offer when the target is not exactly enthusiastic about being taken over. As you prepare the case, consider the following questions; 1. Is Nicholson an attractive acquisition candidate for Cooper? What role, if any, would it play in Cooper s overall corporate strategy? 2. What is the maximum price that Cooper can afford to pay for Nicholson and still keep the acquisition attractive from the standpoint of Cooper? Note: There is a good discussion in the case about the synergies the Cooper can impart to Nicholson. This information, coupled with other case data, should allow you to value Nicholson using the WACC method. Assume a WACC of 10 percent for Nicholson as part of Cooper. 3. What are the concerns and what is the bargaining position of each of Nicholson shareholders? What must Cooper offer each group in order to acquire its shares? Note: To deal with this issue, try to think about what options each player has at this point in the discussion. 4. Assume that Cooper management wants to acquire at least 60 percent of the outstanding Nicholson stock and make the same offer to all stockholders, what offer must Cooper management make - in terms of dollars per share and of form of payment? To conclude our session, John Englar will discuss the hostile takeover of Burlington Industries in 1987 and the issues that the management team and Board faced. Session 4, April 5 th 4

5 In the first part of the session we will take a look at the Yeats Valve and Control, Inc. case. Your task as students is to value Yeats Valve from the perspective of TEI International as well as setting the terms of the acquisition under the assumption that TEI will pay for Yeats through an exchange of stock. As you prepare the case, consider the following questions: 1. What is the situation faced by both Yeats Value and TEI International? What are their relative competitive strengths and weaknesses? Why should each of these companies want to negotiate a merger? 2. How much is Yeats Value worth per share? What appear to be the key assumptions in establishing the value of Yeats? What price and exchange ratio would you recommend for the combination of Yeats and TEI? 3. Are there any post-combination management issues that need to be addressed? We ll finish our session with a look at the Brown-Forman Distillers Corporation (BFD) case. The decision problem facing the CEO of BFD is whether to buy Southern Comfort at the asking price of $94.6 million. While financial considerations play a role in the decision, there are issues of strategic fit and product positioning should emerge as interesting issues for class discussion. While preparing the case, please consider the following questions: 1. Identify the key competitive characteristics of the distilling industry. How has BFD attempted to position itself within this industry? Does its strategy appear to be working well? 2. Assess the proposed acquisition in terms of strategic fit. 3. Brown-Forman is assuming that a 14 percent cost of capital for this acquisition. Is this a reasonable number? There s data in the case to test this figure do some calculations! 1 4. How much is Southern Comfort worth? What are the key assumptions in valuing this acquisition? In particular, how much of Southern Comfort s worth is associated with the estimate of the firm s terminal value? How does product positioning play into all of this? 5. What should BFD do? Session 5, April 12 th 1 To calculate the cost of capital, you will have to use the capital asset to calculate the cost of equity capital. The case writer has provided two estimates for the market risk premium; one based on an arithmetic average, the other on the geometric mean. Use the arithmetic mean; your instructor will explain why during class. 5

6 We ll start this session with a look at Sybron Corporation. The case is an example of a bust-up LBO from the standpoint of a buy-out specialist who is reviewing the opportunity to take the firm private. The following questions should guide your analysis: 1. Is Sybron a suitable target for an LBO? Why, or why not? 2. From a strategic standpoint, which businesses should be sold and which retained? How much cash could be raised from the businesses sold? Note: The case provides you with sufficient data to use the P/E multiple approach to value each of the units. 3. Beyond the divestitures identified in (2), what other operating changes would you make in Sybron after acquisition? 4. The case makes it clear that a winning bid would have to exceed the $25.95 a share already bid by Kelso. Does Sybron appear to be worth more than $25.95 a share? For the later half of this period, we will examine the Eskimo Pie Company case. Eskimo Pie is a marketer of branded frozen novelties. The company is owned by Reynolds Metals, a maker of a wide range of aluminum products. Reynolds wants sell its stake in Eskimo Pie so that it can focus on its core aluminum business. The Eskimo Pie case presents students with a corporate decision that depends on a (relatively) simple valuation of a firm. The valuation can be approached using a discounted cash flow analysis of by using a variety of comparable public firms trading multiples. The managerial issues in the case focus on the ability of Eskimo Pie to successfully complete the proposed offering at a fair price. In this respect, the valuation aspects of the case are much like initial public offerings. As you prepare the case, consider the following questions: 1. What is your estimate of the value of Eskimo Pie Corporation (EPC)? 2. Why would Nestle want to acquire EPC? Are there potential synergies? Is Eskimo Pie worth more to Nestle than it is worth as a stand-alone company? 3. As an advisor to Mr. Reynolds, would you recommend the sale to Nestle or the proposed initial public offering? Session 6, April 19 th The Gulf Oil Takeover case is not a candidate for write-up. Why? The case requires some knowledge of the economics of oil and gas production and exploration that most students don t have. The case is useful as a walk-through in providing students with an opportunity to evaluate why large premiums can be justified on takeovers of very big public companies if the acquirer is willing to fundamentally change the way the target conducts business. To see what is going on, we ll look at Gulf s production and drilling operations as a huge capital 6

7 budgeting project and demonstrate that it makes little sense for Gulf (or whoever owns Gulf) to continue to spend $2.2 billion a year to replace its oil reserves. In reading this case, please think about the following questions: 1. What are the gains to Gulf stockholders from the takeover bid? 2. How will the potential acquirers extract a profit after buying Gulf at a substantial premium over its pre-offer price? 3. What s the value of Gulf s exploration and development program? 4. What strategy should Socal take if it acquires Gulf Oil? What are the risks in this strategy? During the second half of the session, we ll look at the legal and ethical dimensions of insider trading when we consider the Anheuser-Busch and Campbell Taggart Inc. case. This case concerns the decision faced by the general counsel of Anheuser-Busch about whether he should file suit against any parties responsible for insider trading in Campbell Taggart, an acquisition target of Anheuser-Busch. We ll try to keep the discussion away from technical legal points by considering the following issues: 1. Does it appear that anyone did anything illegal in this case? Unethical? Who? What? 2. How was Anheuser-Busch damaged in this incident? How might you go about assessing the economic damage due to insider trading? Can the stock histories in the case be used to assess the damages in this case? (You can assume that the answer is yes. The challenge is to use the case data to come up with a dollar amount.) How would you assess the noneconomic damage? 3. Insider trading is viewed as an extremely serious problem in the United States. Do we take insider trading too seriously? Why don t we just allow folks to trade on the basis of inside information? 4. To whom is Anheuser-Busch responsible for in this incident? What should Mr. Suhre do? For background reading on the regulatory and legal aspects of mergers, see Section 7 in the monograph. Session 7, April 26 th For the first part of this period, we ll look at the John Case Company case that is an example of a management buy-out (MBO). The senior management of the firm has the opportunity to buy the company from its sole owner. The asking price is $20 million. The would-be purchasers can muster only $500,000; therefore, the group will be faced with the challenge of raising the balance from external sources. Analysis of the case requires that one determine the attractiveness of the business. In particular, students need to determine whether the present owners asking price looks fair, and to design a financing package that will meet the needs and objec- 7

8 tives of a wide variety of suppliers of funds. In addition, students must establish a business plan that will enable the purchasing group to realize a satisfactory return on their investment. Adopting the viewpoint of an advisor to Mr. Johnson and the other managers, consider the following questions as you prepare the case: 1. How attractive is the business they are planning to buy? What are its key operating and competitive characteristics? 2. Based on the data in case Exhibit 5, does the $20 million asking price appear to be fair? 3. How should the management group finance the buy-out? Can the company support as much as $19.5 million of debt? In light of the firm s existing level of cash and marketable securities (see case Exhibit 2), is $19.5 million in debt really necessary? 4. What is the venture capitalist likely to require as a condition for providing funds? 5. What terms and conditions should management accept on the sources of external financing? Are the conditions on the current commitments satisfactory? If not, how would you suggest changing them? 6. If the buyout is successful, how should Case subsequently be managed? Should the proposed product line expansion, for example, be pursued? After break, we ll look at Philip Morris acquisition of Kraft, Inc. The setting provides another look at the takeover market and how firms try to use restructuring as an anti-takeover devise. While the case is data rich, we ll avoid the number crunching component of the case associated with the restructuring plan being proposed by Kraft, and focus on issues of strategic fit and market dynamics. Prepare the case with the following questions in mind: 1. Why is Kraft a takeover target? 2. Should Philip Morris acquire Kraft? What, if any, are the potential synergies from the acquisition? Who is the major beneficiary of these synergies? Note: There s data in the case that can allow you to value the synergies in dollar terms. Do it! Students who ignore this piece cannot expect to get a A in the case. 3. What do you make of Kraft s proposed restructuring plan? 4. How would you assess the stock price information in case Exhibit 13? What interplay of events is contributing to the changes in share price? What s the market trying to tell us? 5. Should Philip Morris increase its bid for Kraft? If your answer is yes, speculate on what will happen to the price of Philip Morris common stock. Session 8, May 3 rd 8

9 We will use this session to hear student presentations of the acquisition transaction studied in their class project. Presenters should plan a 10-minute discussion of the strategic purposes of the deal and their assessment of its prospects for success. Questions/challenges from the class will be encouraged (and count toward your participation grade). TERM PROJECT 9

10 Each student must analyze a current merger transaction selected from the attached Exhibit A. Selections must be noted to the professor no later than the end of the second class meeting. An analysis meeting the criteria and format must be turned in by April 26. This analysis will count for 40% of the course grade; the amount of time and energy you place in this project should reflect its relative weighting in the final grade. Analysis Format Identify the parties to the transaction, including affiliates if relevant. Review Board Members for possible conflicts of interest or advantages. State the strategic objectives of each party. What are the key success factors in the transaction? Hypothesize on what risks exist and what unforeseen circumstances might occur that will cause the transaction to fail or not meet the strategic objectives. What is the structure of the transaction? Why does it appear that this particular structure was chosen? What alternatives may have been considered and why may they have been rejected? How has the target been valued? Comment on the appropriateness of the apparent method and alternatives? What synergies did the parties identify? Do these appear to be realistic? In your proforma financials (see below), this should be a key line item in which you attempt to assess available information to value and reflect the synergies. What are the economic (after-tax) consequences to each part/constituency of the transaction? What regulatory hurdles stand in the way of a successful completion? What are the key issues to overcome? List major implementation steps (at least 5) and outline a timetable. Hypothesize what issues will be the most difficult to overcome in completing the transaction and implementing a successful integration. What impact will the transaction have on both management teams? Speculate on what the most difficult issues were/are? Describe the issues in the HR/benefits area that must be addressed. Do you perceive any ethics issues in this transaction? Create abbreviated pro-forma financial statements for the transaction. Analyze, in depth, one line item that appears to be the most material (synergies?). An example will be provided in the first class meeting. These may be available in the SEC filings fine: abbreviated them and demonstrate your understanding of the key issues. Conclude your analysis with your forecast for the success of the transaction. You will present this in the last class session. 10

11 Methodology Because these are current transactions, considerable information exists is SEC filings, press releases, analysts reports and business new media. You are expected to review these materials and cite them. As long as you make reference to your source(s), e.g. company proxy or Business Week article, dated, you are free to adopt the ideas and opinions of others; exact citations and quotations are not necessary. It is you assessment of the opinions and facts you access and marshal to draw your conclusions that will drive your grade. This is the essence of good management in the M&A field (and of successful investing). Analyses should be more than 10 but less than 26 pages, in 14/16-point font, plus exhibits. Follow the sequence set forth above. You may attach as many supporting exhibits to your analysis as you wish, but these are required and you will not be graded on them. 11