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In recent years, it has become fairly common for computer hardware and software companies to merge with one another in an effort to gain economies of scale and scope and thus be better able to compete with larger rivals in the marketplace. The mergers are generally either horizontal (for example, when two software companies merge to expand their product lines) or vertical (for example,when a hardware company acquires a software company to obtain software to package with itscomputers.)
CompuTech Industries was recently bitten by the merger bug. The company was founded byMarco Garibaldi in the basement of his parents’ home in 1983. Garibaldi had no intentions of competing with the “giants” in the industry (Microsoft, Lotus, etc.), but rather finding a market niche of his own. Garibaldi envisioned selling software to individuals at a low economical price and grabbing the low-price end of the market.
Garibaldi was a mathematical wizz and “computer hacker” who had dropped out of collegebecause he was not intellectually challenged. The idea for CompuTech actually originated fromone of Marco’s other hobbieswriting science fiction novels. Although Marco enjoyed concoctinghis sci-fi stories, he hated spending endless hours retyping manuscripts to correct his typographicalerrors. He surmised that college students probably disliked this chore at least as much as he did, sohe set out to develop a user-friendly word processing computer program aimed at high school andcollege level students. He called the computer software program WordPro Easy, and it was anovernight success. In fact, the program received wide acceptance from both the academic and thebusiness communities. Marco had not foreseen how quickly CompuTech would grow and theamount of capital that would be necessary to fund its growth. However, he received numerous offersfrom venture capital funds, and this supported early growth. Marco’s goal was to take the firm public, which he did in 1990. By December 31, 1995, CompuTech’s stock was selling for $25 per share, and there were 10 million shares outstanding.
During the company’s 12 years of existence, CompuTech developed a solid reputation foringenuity, reliability, and timely introduction of new products. In addition, unlike many of itsrivals, CompuTech maintains a toll-free telephone technical support service for users, and it usesinformation from the service both to identify and correct potential program bugs and to get ideasfor Product improvements. Consequently, WordPro Easy has been updated frequently, enabling it tomaintain its strong market position. More recently, the firm’s programmers created a presentation
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packagecalled Chart Easy that has alsoreceiiivyedfreweidfreommaerrkreotrsa.cceptancebecause,alrikkeet.WitofroduPnrdoEasy, it is innovative, easy to use, andrelativelyHowever, when CompuTech attempted to enter the financial spreads
partly due to the market s
notpecaughtrceptperception,tthat thetthl yedfiuremto
s
the going much rougher. Its product. Spreadsheet Easy, has simply
CompuTech’s late entrance into the market, par
expertise is not financial software, and partly because other firms’sGaribaldi
established hold on the market. This failure to enter thefinancial
worried, because rival software companies are increasingly bundlingv.Garibaldiribtheirfweoarrs.wordpcororrceecstsliyngt.hapirei–t.sentation, and financial software programs into one “office suite.
CompuTech were to follow the market and bundle its software programs mmsairnkteotafnoollfofiwcienpga. cGkaargieb,atlhdeipackage would fail because Spreadsheet Easy doesn’t have a strong
believesthatCompuTech’s continued success lies in finding a firm which enjoys
ansadsibmriinlagrsrwepituhtaii
reputa-
tion to CompuTech’s, but one that specializes in financial spreadsheet pro
a strong market following.
One potential acquisition candidate is Computer Concepts Inc. (CCI), a firm that specializesin accounting, finance, and tax return software programs. Like CompuTech, CCI was founded in theearly 1980s, expanded with the help of venture capitalists, and went public in 1993. (Three millionshares had been offered at $1.25 per share, and 2.5 million shares were actually sold to raise $2.5 million, net of underwriting fees.) CCI’s financial spreadsheet program, Model Pro, was an initial success and has been continually updated to meetchangingmarket demands. Consequently, it has anexcellent market following. Also, Model Pro was written so that a spreadsheet created by it could be incorporated as text into most word processing programs (including WordPro Easy). The firm’s oneperceived weakness is its lack of diversity in software product offerings. Garibaldi views a mergerwith CCI as a perfect fit with CompuTechsuch a merger would provide a way for CompuTech to enter the financial software market and thus solve his office suite problem.
The primary issues now facing CompuTech are (1) how much to offer for CCI’s stock and(2)how to approach CCI’s management. Marco Garibaldi and his staff are good at developingcomputer software programs, but they are not finance experts and are not experienced with acquisitions. So, rather than taking a chance on making a mistake, they decided to bring your consultingfirm in to advise them on the CCI merger.
Table 1 provides some information on CCI. The stock is traded infrequently and in smallblocks, and while the last trade was at a price of $1.50, it would probably run up sharply if a largebuy order were placed. CCI’s beta coefficient is 1.6, and that number is close to the average betafor publicly traded computer software companies. If the acquisition takes place, CompuTech wouldincrease CCI’s debt ratio from 10 to 25 percent, and consolidation of income for taxpurposeswould move CCI’s 30 percent federal-plus-state tax rate up to that of CompuTech’s, 40 percent.
CCI’s management owns about 30 percent of the stock, which is substantial but not enough tocompletely block a merger. They might fight to keep the firm independent if CompuTech makes anoffer, but there is a chance that they would welcome a chance to sell out. They also might want toremain active, but wouldappreciatebeing acquired by a firm which would provide them with product diversity, something that it is currently lacking. To the best of Marco Garibaldi’sknowledge,CCI’s managers have had no discussions with anyone about a merger, and the few analysts who followthestock have not said anything about the possibility of a takeover. However, Garibaldi isafraid some other software company might force a bidding war if CompuTech decides to make anoffer. CCI does not appear to be large enough to interest companies likeIBM or Microsoft,but sucha company might decide to buyCCI for its accounting and tax applications and then cultivate them.
Marco Garibaldi wants your opinion on how CompuTech should approach CCI’s management. should he decide to make an offer. One possibility would be to go to its management witharelativelylow offer which could later be increased if necessary. Another would be to come inwithahigh offer and attempt to preempt any outside challenge. Athird plan would be to by-pass man-
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agement altogether and make a tender offer directly to CCI’s stockholders. So, part of your task istodiscuss the pros and cons of these approaches, plus any others you might think of.CompuTech has, in the past, built its software business “from the ground up” rather than
rough acquisitions, and some of Garibaldi’s managers prefer internal expansion to acquisitions.th
Therefore. Garibaldi wants you to include, in your report and presentation, a discussion of mergersversus business creation to achieve CompuTech’s strategic objectives. He also wants you to comment on whether there might be any legal impediments to a merger with CCI. A discussion of thepros and cons of a hostile versus a friendly merger would also be helpful.
The proper price to offer is a critical issue. CCI’s most recent stock price was $1.50 per share,and there are 3,000,000 shares outstanding. That suggests that CCI’s value is $4.5 million. However, analysts often look at other data when appraising the value of stocks such as CCI for acquisition purposes, and they consider valuation multiples such as those shown in Table 1. The weights given tothe different multiples are somewhat arbitrary, and they vary from situation to situation. Also,some analysts rely almost totally on a DCF calculation and use the multiples, if at all, simply as acheck to see if their DCF analysis is in the right ballpark. The multiples given in Table 1 are recent averages for software companies, but actual multiples for individual companies vary substantially depending on the circumstances. Higher multiples are generally used for more rapidly growing firms,or for firms with more growth potential, while lower multiples are used for highly leveraged firms.
In addition, the stock prices of independent companies are frequently bid up over their goingconcern values once investors start thinking of them as acquisition candidates. Garibaldi does notthink such a “merger premium” is reflected in CCI’s current stock price, but he is not sure about this. If no merger premium is currently embodied in the price, then CompuTech would probably have tooffer a premium to get CCI’s stockholders to agree to sell. So, Garibaldi wants to know the maximum price CompuTech could afford to pay without diluting its own value. He also wants to knowthe minimum price CCI’s stockholders are likely to accept. Then, if the price CompuTech can affordexceeds the price CCI will accept, a merger is at least feasible.
To find the maximum price CompuTech can pay, Garibaldi wants you to develop pro formafinancial statements and then use them to determine the cash flows CompuTech would realize if itbuys CCI. The present value of those cash flows can then be used to estimate the maximum offerprice. Of course, Garibaldi would like to buy CCI at a lower price, because the merger will notbenefit CompuTech’s current stockholders unless it can be completed at a price less than the PV ofthe cash flows.
It may turn out that CCI’s management would welcome a merger, in which case they maynot bargain too hard. However, since the management team owns 30 percent of the stock, they willwant to get a high price, and that (plus a legal obligation to do so) might lead them to solicit competing bids. Also, you know that CCI’s management team is relatively young and aggressive, so theyprobably will not want to retire. Therefore, what they are offered in terms of employment, and theircompensation package, will have an effect on their attitude toward a merger. Garibaldi wants youto address that issue.
Table 2 contains some pro forma financial data that Garibaldi’s people worked up from the setof data CCI disclosed as a part of its recent public offering. The data in Table 2 assume a takeoverby CompuTech. The required addition to retained earnings represents the amounts that would benecessary to finance the projected growth. Although specific estimates were only made for 1996 through 1999, the acquired company would be expected to grow at a 5 percent rate in 2000 andbeyond. However, actualcgrcor,sgrowth could be greater or less than the expected growth rate, and thiswould significantlythe
estimated important part of the merger analysis involves determining a discount rate to apply to
mated cash flows. In its merger work, your consulting firm uses a procedure developed byProfessor Robert Hamada of the University of Chicago to adjust betas to reflect differing degreesof financial leverage. Hamada’s basic equations are given below:
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Formula to unlever beta:bu–—-71(1EW1+(Formula to relever beta:bL= hu[ +( 1-T)(D/S)).
Here buis the beta that CCI would have if it used no debt financing (the inherent beta of the assets). T is the applicable corporate tax rate, and D/S is the applicable market value debt:to-equityratio. As shown in Table 1, the T-bond rate is 6.5 percent, and your firmis economists estimate that
the market risk premium is currently 5 percent.
Your task now is to complete a report in which you first address the issue of whether or notCompuTech should attempt to take over CCI. Based on your discussions with Garibaldi, you knowthat you should consider questions such as the following: If an attempt is to be made, how muchshould CompuTech offer, what is the maximum price it can afford to pay, and how would CCI’s current management be likely to respond? Would CompuTech want CCI’s current management team tostay on, or would CompuTech be better off if it replaced CCI’s managers with its own people? Dothe ratios provided in Table 2 look reasonable, or do they cast any doubts on the forecasts? Should CCI’s stockholders be offered cash, debt securities, or stock in CompuTech? In addition to the projected cash flows, is there the potential for some “strategic option value” if CCI is acquired. and ifso. how should this be factored in? Recognize that either Garibaldi or one of the other CompuTechmanagers could ask you follow-upyou should thoroughly understand the implications of your analysis. To help structure your report, answer the following questions.
QUESTIONS
1.Several factors have been proposed as providing a rationale for mergers. Among the moreprominent ones are (I) tax considerations, (2) diversification, (3) control, (4) purchase ofassets below replacement cost, and (5) synergy. From the standpoint of society, which ofthese reasons are justifiable? Which are not? Why is such a question relevant to a companylike CompuTech, which is considering a specific acquisition? Explain your answers.
2.Briefly describe the differences between a hostile merger and a friendly merger.Isthere anyreason to thinkthat acquiringcompanies would, on average, pay a greater premium over target companies’ pre-announcement prices in hostile mergers than in friendly mergers?
3.Complete CCI’s cash flow statements for 1996 through 1999. Why is interest expense typically deducted in merger cash flow statements, whereas it is not normally deducted in capitalbudgeting cash flow analysis? Why are retained earnings deducted to obtain the free cashflows?
4.Conceptually, what is the appropriate discount rate to apply to the cashflows developedin
Question 3? What is the numerical value of the discount rate? How much confidence can
one place in this estimate, i.e., is the estimated discount rate likely to be in error by a small
amount, such as 1 percentage point, or a large amount, such as 4 or 5 percentage points?
Would an error in the discount rate have much of an effect on the maximum offer price?
5.What is the terminal value of CCI, that is, what is the 1999 value of the cash flows CCI isexpected to generate beyond 1999? What is CCI’s value to CompuTech at the beginning of1996? Suppose another firm was evaluating CCI as a potential acquisition candidate. Would
theyobtain the same value? Explain.
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6aCCI’s management has a substantial ownership interest in the company, but not enough *to block a merger. If CCI’s managers want to keep the firm independent, what are some
actions they could take to discourage potential suitors?b.If CCI’s managers conclude that they cannot remain independent, what are some actionsthey might take to help their stockholders (and themselves) get the maximum price for
their stock?
c.If CCI’s managers conclude that the maximum price others are willing to bid for the
company is less than its “true value,” is there any other action they might take that wouldbenefit both outside stockholders and the managers themselves? Explain.
d.Do CCI’s managers face any potential conflicts of interest (agency problems) in theirnegotiations with CompuTech? If so, what might be done to reduce conflict of interestproblems.
7.CCI has 3 million shares of common stock outstanding. The shares are traded infrequentlyand in small blocks, but the last trade, of 500 shares, was at a price of $1.50 per share.Based on this information, and on your answers to Questions 5 and 6, how much shouldCompuTech offer for CCI, and how should it go about making the offer?
8.Do you agree that synergistic effects probably create value in the average completedmerger? If so, what determines how this value is shared between the stockholders of theacquiring and acquired companies? On average, would you expect more of the value to go tothe acquired or to the acquiring firm? Explain your answers.
9.A major concern when analyzing any merger is the accuracy of the cash flows. How wouldthe maximum price vary if the variable cost percentage were greater or less than theexpected 80 percent? If you are using the spreadsheet model, do a sensitivity analysis on thevariable cost ratio, and also determine the maximum percentage that would justify a price of$3.50 per share. If you do not have access to the spreadsheet model, simply discuss theissue, and explain why managers would be interested in such a sensitivity analysis.
10.What rate of return on equity is projected in the analysis? Should the projected ROE make
you want to question the assumptions that went into the cash flow and financial statementprojections?
11.Would the response of CCI’s stockholders be affected by whether the offer was for cash orfor stock in CompuTech? Explain.
12.What are your final conclusions? Should CompuTech make an offer, and if so, should theytry for a friendly deal; what price per share should they offer; how should they make payment; and should they try to retain the present management’?
