Description

Examination Questions and Answers

True/False Questions: Answer True or False to the following questions.

1. The integration process if done effectively can help to mitigate the potential loss of employees. True or False

Answer: True

1. Integration is among the most important factors contributing to the success or failure of mergers and acquisitions. True or False

Answer: True

1. Rapid integration helps to realize the planned synergies and may contribute to a higher present value for the merger or acquisition. True or False

Answer: True

1. High employee turnover is rarely a problem during the integration of the target firm into the acquirer. True or False

Answer: False

1. High employee defection during the integration period is an excellent way to realize cost savings?

True or False

Answer: False

1. Employees or so-called “human capital” are often the most valuable asset of the target firm. True or False

Answer: True

1. Employees of both the target and acquiring firms are likely to resist change following a takeover. True or False

Answer: True

1. Differences in the way the management of the acquiring and target firms make decisions, the pace of decision-making, and perceived values are common examples of cultural differences between the two firms. True or False

Answer: True

1. Focus on customers is generally considered a factor critical to the ultimate success or failure of the merger or acquisition. True or False

Answer: True

1. Revenue growth is often sacrificed in an effort to engage in aggressive cost cutting during the integration period. True or False

Answer: True

1. Divulging the true intentions of the acquiring firm to the target firm’s employees should be deferred until it can be determined that such employees can be trusted. True or False

Answer: False

1. Communication plans should be developed for all stakeholder groups except for suppliers, because they generally have a lower priority in the integration process. True or False

Answer: False

1. Developing staffing plans involves identifying staffing requirements and developing a compensation strategy, among other things. True or False

Answer: True

1. Co-locating employees from the acquiring and target firms is rarely a good idea early in the integration period because of the inevitable mistrust that will arise. True or False

Answer: False

1. So-called contract related transition issues often involve how the new employees will be paid and what benefits they should receive. True or False

Answer: True

1. Employee health care or disability claims tend to escalate just before a transaction closes, thereby adding to the total cost of the transaction. Who will pay such claims should be determined in the agreement of purchase and sale. True or False

Answer: True

1. In hostile takeovers, the employees that are on the post-merger integration team should come from the acquiring firm because of concerns that the target firm’s employees cannot be trusted.

True or False

Answer: False

1. The management integration team’s primary responsibilities should be monitoring the daily operations of the work-teams assigned to complete specific tasks during the integration.

True or False

Answer: False

1. The management integration team’s primary responsibilities should be to focus on achieving long-term profit goals, monitoring actual performance to the goals of the integration plan, and on cost management. True or False

Answer: True

1. An acquiring firm that focuses heavily on integrating a target firm, which represents a sizeable portion of its total operations, frequently sees deterioration in its own current operating performance. True or False

Answer: True

1. It is generally more important to respond to current issues as they arise in your communication plans even if it results in the appearance of a somewhat inconsistent theme throughout communications made to stakeholders. True or False

Answer: False

1. Key stakeholders in the integration effort generally include employees, customers, suppliers, communities, and regulators. True or False

Answer: True

1. A newly merged company will often experience at least a 5-10% loss of current customers during the integration effort. True or False

Answer: True

1. Following an acquisition, long-term contracts with suppliers can generally be broken without redress. True or False

Answer: False

1. In building a new organization for the combined firms, it is important to start with a clean sheet of paper and ignore the organizational structures that existed prior to the merger or acquisition.

True or False

Answer: False

1. Highly decentralized organizational structures generally expedite the integration effort more so than highly centralized structures. True or False

Answer: False

1. The extent to which compensation plans for the acquiring and acquired firms are integrated depends on whether the two companies are going to be managed separately or fully integrated. True or False

Answer: True

1. Benchmarking important functions such as the acquirer’s and the target’s manufacturing and information technology operations and processes is a useful starting point for determining how to integrate these activities. True or False

Answer: True

1. When two companies with very different cultures merge, the new firm inevitably adopts one of the two cultures that existed prior to the merger. True or False

Answer: False

1. Sharing common goals, standards, services, and space can be a highly effective and practical way to integrate disparate corporate cultures. True or False

Answer: True.

1. It is crucial to focus on the highest leverage issues in implementing post-merger integration. True of False

Answer: True

1. A merger agreement should specify how the seller should be reimbursed for products shipped or services provided by the seller before closing but not paid for by the customer until after closing. True or False

Answer: True

1. Pre-closing integration planning is likely to be easier in friendly than in hostile transactions. True or False

Answer: True

1. Customers of newly acquired firms are usually slow to switch to other suppliers even if product quality deteriorates due to inertia. True or False

Answer: False

1. Decentralized management control usually facilitates the integration of a newly acquired business. True or False

Answer: False

1. Merging compensation systems can be one of the most challenging activities of the integration process. True or False

Answer: True

1. Benchmarking important functions such as the acquirer’s and the target’s manufacturing and IT operations and processes is a useful starting point for determining how to integrate these activities. True or False

Answer: True

1. Plant consolidation rarely requires the adoption of a common set of systems and standards for all manufacturing activities. True or False

Answer: False

1. The extent to which the sales forces of the two firms are combined depends on their relative size, the nature of their products and markets, and their geographic location. True or False

Answer: True

1. Enabling the customer to see a consistent image in advertising and promotional campaigns is often the greatest challenge facing the integration of the marketing function. True or False

Answer: True

1. The speed with which two firms are merged is an important factor determining the long-term success of the merger. True or False

Answer: True

1. Whenever possible, integration planning should begin before closing. True or False

Answer: True

1. Newly merged firms frequently experience a loss of existing customers as a direct consequence of the merger. True or False

Answer: True

1. Integration planning involves addressing human resource, customer, and supplier issues that overlap the change of ownership. True or False

Answer: True

1. Integration of a new business into an existing one rarely affects current operations of either business. True or False

Answer: False

1. When news about the integration is bad, it is critical never to share it with employees. True or False

Answer: False

1. The newly integrated firm must be able to communicate a compelling vision to investors. True or False

Answer: True

1. An effective starting point in setting up a structure is to learn from the past and to recognize that the needs of the business drive structure and not the other way around. True or False

Answer: True

1. Staffing plans should be postponed to relatively late in the integration process. True or False

Answer: False

1. The extent to which compensation plans are integrated depends on whether the two companies are going to be managed separated or integrated. True or False

Answer: True

Multiple Choice Questions: Circle only one of the alternatives.

1. Rapid integration is usually important for all of the following reasons except for
2. Minimizes employee turnover
3. Improves the morale and productivity of current employees of both the acquiring and acquired firms
4. Builds confidence in current employees in the competence of management
5. Dispenses with the need for pre-integration planning
6. Reduces customer turnover

Answer: D

1. All of the following are often cited as factors critical to the ultimate success of the integration effort except for
2. Plan carefully, act quickly
3. The use of project management techniques
4. Early communication from the top of the organization
5. Salary and benefit reductions for many employees of the acquired company in order to realize cost savings
6. Making the tough decisions as early as possible

Answer: D

1. Certain post integration issues are best addressed prior to the closing. These include all of the following except for
2. Who will pay for employee severance expenses
3. How will employee payroll be managed during ownership transition
4. What will be done with checks from customers that the seller continues to receive after closing
5. How will the seller be reimbursed for monies owed to suppliers for products sold prior to closing
6. Who will pay for health care and disability claims that often arise just before a business is sold?

Answer: D

1. Which of the following is not true about the primary responsibilities of the management integration team (MIT)?
2. The MIT should direct the daily operations of the individual work teams set up to implement certain activities.
3. Focus the organization on meeting ongoing business commitments and operational performance targets
4. The creation of an early warning system to determine when performance targets are likely to be missed.
5. Establish a rigorous communication program
6. Establishing a master schedule of what should be done by whom and by what date.

Answer: A

1. Which of the following is generally not true about communication during the integration period?
2. Communication should be as frequent as possible
3. Employees should be sheltered from bad news
4. The CEO of the combined firms should lead the effort to communicate to employees at all levels
5. Regularly scheduled employee meetings are often the best way to communicate progress to plan
6. The reasons for changing work practices and compensation must be thoroughly explained to employees

Answer: B

6, Customer attrition following an acquisition is commonly related to uncertainty about

1. On time product delivery
2. Product quality
3. Pricing and payment terms
4. A and B only
5. A, B, and C

Answer: E

1. All of the following are generally considered stakeholders in the integration process except for
2. Suppliers
3. Employees
4. Competitors
5. Regulators
6. Customers

Answer: C

1. All of the following are generally true about creating new organizations except for
2. Learn from prior organizational strengths and weaknesses
3. Business needs should drive structure and not the reverse
4. Centralized organizations facilitate the pace of the integration
5. The structure employed during the integration must be the one used in the long-run
6. Senior managers should be given responsibility for selecting their own subordinates

Answer: D

1. Developing staffing plans requires which of the following?
2. Identifying personnel requirements
3. Determining the availability of skilled employees to fill these requirements
4. Developing compensation plans
5. A and B only
6. A, B, and C

Answer: E

1. All of the following are true about the challenges of integrating firms with different corporate cultures except for
2. Cultural issues can run the gamut from dress codes to compensation
3. The acquired firm’s overarching culture is generally rapidly accepted by the target firm’s employees
4. Small companies are usually highly unstructured and informal
5. There are often differences in culture even between firms in the same industry
6. Integration may be inappropriate if acquirer and acquired firm’s cultures are extremely different.

Answer: B

1. Which of the following represent commonly used techniques for integrating corporate cultures?
2. Employees are encouraged to share the same overall goals
3. “Best practices” in one department are employed in other departments
4. Multiple businesses share the same service such as the legal department
5. Employees are co-located
6. All of the above

Answer: E

1. Which of the following is not true about integrating business alliances?
2. Teamwork is the underpinning that makes alliances work.
3. Control is best exerted through coordination
4. Decisions are made at the top of the organization
5. Decisions are based on the premise that all participants to the alliance have had an opportunity to express their opinions.
6. The failure of one party to meet commitments will erode trust

Answer: C

1. Successfully integrated mergers and acquisitions are frequently those which
2. Communicate candidly and continuously
3. Appoint an integration manager and team with clearly defined goals and responsibilities
4. Establish well defined lines of authority
5. Focus on issues that have the greatest near-term impact
6. All of the above

Answer: E

1. Post-closing integration may be viewed in terms of a process consisting of the following activities
2. Integration planning
3. Developing communication plans
4. Creating a new organization
5. Developing staffing plans
6. All of the above

Answer: E

1. The acquirer’s sales force sells very complex software solutions to its customers. The target firm manufactures commodity hardware products. Customers of the two firms sometimes buy both products. The benefits of integrating the sales force of both the acquirer and target firms includes all of the following except for
2. Generates significant cost savings by eliminating duplicate sales representatives
3. Eliminates related sales support expenses
4. Minimizes potential customer confusion by enabling customers to deal with a single sales representative
5. Facilitates communication of a consistent brand image
6. Makes product cross-selling more effective

Answer: E

1. The post-closing integration process consists of all of the following activities except for

1. Integration planning
2. Developing communication plans
3. Creating a new organization
4. Developing staffing plans
5. Identifying the acquisition vehicle

Answer: E

1. Which of the following activities are likely to extend beyond what is normally considered the conclusion of the post-closing integration period?

1. Developing communication plans
2. Cultural integration
3. Integration planning
4. Developing staffing plans
5. None of the above

Answer: B

1. Delay in integrating the acquired business contributes to which of the following?

1. Employee anxiety
2. Customer attrition
3. Employee anxiety
4. Deteriorating employee productivity
5. All of the above

Answer: E

1. Successfully integrated M&As are those that demonstrate leadership by candidly and continuously communicating which of the following?

1. A clear vision
2. A set of values
3. Unambiguous priorities for each employee
4. A & B only
5. A, B, & C

Answer: E

1. Which of the following represent important decisions that must be made early in the integration process?

1. Identifying the appropriate organizational structure
2. Defining key reporting relationships
3. Selecting the right managers
4. Identifying and communicating key roles and responsibilities
5. All of the above

Answer: E

1. Poorly executed integration often results in high employee turnover. The costs of such turnover include which of the following?

1. Declining morale among those that remain
2. Retraining costs
3. Declining productivity
4. Deteriorating customer service
5. All of the above

Answer: E

1. Which of the following factors affect customer attrition that normally accompanies post-merger integration?

1. Customer uncertainty about on-time delivery
2. More aggressive pricing from competitors
3. Deteriorating customer services
4. Deteriorating product quality
5. All of the above

Answer: E

1. Which of the following is not true about the recommendation that integration should occur rapidly?

1. All significant operations of the two firms must be integrated immediately.
2. Rapid integration helps to minimize customer attritition.
3. Rapid integration reduces unwanted employee turnover.
4. Rapid integration reduces employee anxiety.
5. None of the above

Answer: A

1. Key management integration team responsibilities include all of the following except for

1. Building a master schedule of activities that need to be accomplished
2. Establishing work teams
3. Tracking the daily operation of the firms
4. Monitoring and expediting key decisions
5. Establishing a rigorous communications program

Answer: C

1. When corporate cultures are substantially different, it may be appropriate to

1. Integrate the businesses as rapidly as possible
2. Leave the businesses separate indefinitely
3. Initially leave the businesses separate but integrate at a later time
4. A or B
5. B or C

Answer: E

Case Study Short Essay Examination Questions

Alcatel Merges with Lucent, Highlighting Cross-Cultural Issues

Alcatel SA and Lucent Technologies signed a merger pact on April 3, 2006, to form a Paris-based telecommunications equipment giant. The combined firms would be led by Lucent’s chief executive officer Patricia Russo. Her charge would be to meld two cultures during a period of dynamic industry change. Lucent and Alcatel were considered natural merger partners because they had overlapping product lines and different strengths. More than two-thirds of Alcatel’s business came from Europe, Latin America, the Middle East, and Africa. The French firm was particularly strong in equipment that enabled regular telephone lines to carry high-speed Internet and digital television traffic. Nearly two-thirds of Lucent’s business was in the United States. The new company was expected to eliminate 10 percent of its workforce of 88,000 and save $1.7 billion annually within three years by eliminating overlapping functions.

While billed as a merger of equals, Alcatel of France, the larger of the two, would take the lead in shaping the future of the new firm, whose shares would be listed in Paris, not in the United States. The board would have six members from the current Alcatel board and six from the current Lucent board, as well as two independent directors that must be European nationals. Alcatel CEO Serge Tehuruk would serve as the chairman of the board. Much of Ms. Russo’s senior management team, including the chief operating officer, chief financial officer, the head of the key emerging markets unit, and the director of human resources, would come from Alcatel. To allay U.S. national security concerns, the new company would form an independent U.S. subsidiary to administer American government contracts. This subsidiary would be managed separately by a board composed of three U.S. citizens acceptable to the U.S. government.

International combinations involving U.S. companies have had a spotty history in the telecommunications industry. For example, British Telecommunications PLC and AT&T Corp. saw their joint venture, Concert, formed in the late 1990s, collapse after only a few years. Even outside the telecom industry, transatlantic mergers have been fraught with problems. For example, Daimler Benz’s 1998 deal with Chrysler, which was also billed as a merger of equals, was heavily weighted toward the German company from the outset.

In integrating Lucent and Alcatel, Russo faced a number of practical obstacles, including who would work out of Alcatel’s Paris headquarters. Russo, who became Lucent’s chief executive in 2000 and does not speak French, had to navigate the challenges of doing business in France. The French government has a big influence on French companies and remains a large shareholder in the telecom and defense sectors. Russo’s first big fight would be dealing with the job cuts that were anticipated in the merger plan. French unions tend to be strong, and employees enjoy more legal protections than elsewhere. Hundreds of thousands took to the streets in mid-2006 to protest a new law that would make it easier for firms to hire and fire younger workers. Russo has extensive experience with big layoffs. At Lucent, she helped orchestrate spin-offs, layoffs, and buyouts involving nearly four-fifths of the firm’s workforce.

Making choices about cuts in a combined company would likely be even more difficult, with Russo facing a level of resistance in France unheard of in the United States, where it is generally accepted that most workers are subject to layoffs and dismissals. Alcatel has been able to make many of its job cuts in recent years outside France, thereby avoiding the greater difficulty of shedding French workers. Lucent workers feared that they would be dismissed first simply because it is easier than dismissing their French counterparts.

After the 2006 merger, the company posted six quarterly losses and took more than $4.5 billion in write-offs, while its stock plummeted more than 60 percent. An economic slowdown and tight credit limited spending by phone companies. Moreover, the market was getting more competitive, with China’s Huawei aggressively pricing its products. However, other telecommunications equipment manufacturers facing the same conditions have not fared nearly as badly as Alcatel-Lucent. Melding two fundamentally different cultures (Alcatel’s entrepreneurial and Lucent’s centrally controlled cultures) has proven daunting. Customers who were uncertain about the new firm’s products migrated to competitors, forcing Alcatel-Lucent to slash prices even more. Despite the aggressive job cuts, a substantial portion of the projected $3.1 billion in savings from the layoffs were lost to discounts the company made to customers in an effort to rebuild market share.

Frustrated by the lack of progress in turning around the business, the Alcatel-Lucent board announced in July 2008 that Patricia Russo, the American chief executive, and Serge Tchuruk, the French chairman, would leave the company by the end of the year. The board also announced that, as part of the shake-up, the size of the board would be reduced, with Henry Schacht, a former chief executive at Lucent, stepping down. Perhaps hamstrung by its dual personality, the French-American company seemed poised to take on a new personality of its own by jettisoning previous leadership.

Discussion Questions:

1. Explain the logic behind combining the two companies. Be specific.

Answer: The two firms have overlapping product lines and complementary strengths. As competitors, the combined firms are expected to generate annual cost savings of about 10% by eliminating redundant resources and duplicate positions. Such savings will come from the elimination of overlapping sales forces, back offices, and R&D activities.

1. What are the major challenges the management of the combined companies are likely to face?

How would you recommend resolving these issues?

Answer: Billed as a merger of equals, Alcatel quickly asserted itself by installing Alcatel managers in all senior management positions except for the CEO. Such actions may alienate many former Lucent managers and generate a “brain” drain. Other challenges include language and cultural differences due to the firm’s headquarters centered in France. Moreover, the French government remains a major shareholder in Alcatel and given the reluctance of French unions to accept layoffs, most of the terminations are likely to be centered in Lucent’s U.S. operations. Despite these considerations, Alcatel will have to move quickly to avoid the paralysis that beset Daimler-Chrysler immediately following their merger. Some of the resentment from layoffs may be mitigated by introducing generous severance packages for employees subject to layoff. Continuous and candid communication as to why the firm is taking certain actions may also help to reduce lingering employee anxiety.

1. Most corporate mergers are beset by differences in corporate cultures. How do cross-border

transactions compound these differences?

Answer: Differences in corporate cultures when the firms involved had been competitors can result in especially great challenges during integration due to a lack of trust and cooperation. Such differences are likely to be exacerbated due to cultural differences that are not well understood by managers and employees alike. Consequently, explaining why certain actions are being taken needs to be done in great detail and with the utmost honestly and clarity.

1. Why do you think mergers, both domestic and cross-border, are often communicated by the

acquirer and target firms’ management as mergers of equals?

Answer: The rationale for a merger of equals may be more for public relations than for substantive reasons. Mergers dubbed “mergers of equals” are those in which the firms are relatively alike in size, market value, product offering, etc., and where it is unclear which party is likely to contribute the most to value creation as a result of the merger. Moreover, by dividing up board representation between the two firms or by establishing co-CEOs, the merger is more likely to be supported by their respective boards and management.

1. In what way would you characterize this transaction as a merger of equals? In what ways

should it not be considered a merger of equals?

Answer: While the board of the new company will consist of six members from each of the former boards, it is clear that Alcatel will play the dominant role. Alcatel is larger than Lucent and the shares of the two firms will be listed in Paris, not in the U.S. As a significant shareholder, the French government will influence many strategic decisions. Moreover, the senior management of the new firm will be dominated by former Alcatel managers.

Panasonic Moves to Consolidate Past Acquisitions

­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­Key Points:

• Minority investors may impede a firm’s ability to implement its business strategy by slowing the decision making process.
• A common solution is for the parent firm to buy out or “squeeze-out” minority shareholders

______________________________________________________________________________

Increased competition in the manufacture of rechargeable batteries and other renewable energy products threatened to thwart Panasonic Corporation’s move to achieve a dominant global position in renewable energy products. South Korean rivals Samsung Electronics Company and LG Electronics Inc. were increasing investment to overtake Panasonic in this marketplace. These firms have already been successful in surpassing Panasonic’s leadership position in flat-panel televisions.

Despite having a majority ownership in several subsidiaries, Sanyo Electric Company and Panasonic Electric Works Company that are critical to its long-term success in the manufacture and sale of renewable energy products, Panasonic has been frustrated by the slow pace of decision making and strategy implementation. In particular, Sanyo Electric has been reluctant to surrender decision making to Panasonic. Despite appeals by Panasonic president Fumio Ohtsubo ’s for collaboration, Panasonic and Sanyo continued to compete for customers. Sanyo Electric maintains a brand that is distinctly different from the Panasonic brand, thereby creating confusion among customers.

Sanyo Electric, the global market share leader in rechargeable lithium ion batteries, also has a growing presence in solar panels. Panasonic Electric Works makes lighting equipment, sensors, and other key components for making homes and offices more energy efficient.

To gain greater decision-making power, Panasonic acquired the remaining publicly traded shares in both Sanyo Electric and Panasonic Electric Works in March 2011 and plans to merge these two operations into the parent. Plans call for combining certain overseas sales operations and production facilities of Sanyo Electric and Panasonic Electric Works, as well as using Panasonic factories to make Sanyo products.

The two businesses were consolidated in 2012. The challenge to Panasonic now is gaining full control without alienating key employees who may be inclined to leave and destroying those attributes of the Sanyo culture that are needed to expand Panasonic’s global position in renewable energy products.

This problem is not unique to Panasonic. Many Japanese companies consist of large interlocking networks of majority-owned subsidiaries that are proving less nimble than firms with more centralized authority. After four straight years of operating losses, Hitachi Ltd. spent 256 billion yen ($2.97 billion) to buy out minority shareholders in five of its majority-owned subsidiaries in order to achieve more centralized control.

Discussion Questions

1. Describe the advantages and disadvantages of owning less than 100 percent of another company.
2. When does it make sense to buy a minority interest, a majority interest, or 100 percent of the publicly traded shares of another company?

HP Acquires Compaq—The Importance of Preplanning Integration

The proposed marriage between Hewlett-Packard (HP) and Compaq Computer got off to a rocky start when the sons of the founders came out against the transaction. The resulting long, drawn-out proxy battle threatened to divert management’s attention from planning for the postclosing integration effort. The complexity of the pending integration effort appeared daunting. The two companies would need to meld employees in 160 countries and assimilate a large array of products ranging from personal computers to consulting services. When the transaction closed on May 7, 2002, critics predicted that the combined businesses, like so many tech mergers over the years, would become stalled in a mess of technical and personal entanglements.

Instead, HP’s then CEO Carly Fiorina methodically began to plan for integration prior to the deal closing. She formed an elite team that studied past tech mergers, mapped out the merger’s most important tasks, and checked regularly whether key projects were on schedule. A month before the deal was even announced on September 4, 2001, Carly Fiorina and Compaq CEO Michael Capellas each tapped a top manager to tackle the integration effort. The integration managers immediately moved to form a 30-person integration team. The team learned, for example, that during Compaq’s merger with Digital some server computers slated for elimination were never eliminated. In contrast, HP executives quickly decided what to jettison. Every week they pored over progress charts to review how each product exit was proceeding. By early 2003, HP had eliminated 33 product lines it had inherited from the two companies, thereby reducing the remaining number to 27. Another 6 were phased out in 2004.

After reviewing other recent transactions, the team recommended offering retention bonuses to employees the firms wanted to keep, as Citigroup had done when combining with Travelers. The team also recommended that moves be taken to create a unified culture to avoid the kind of divisions that plagued AOL Time Warner. HP executives learned to move quickly, making tough decisions early with respect to departments, products, and executives. By studying the 1984 merger between Chevron and Gulf Oil, where it had taken months to name new managers, integration was delayed and employee morale suffered. In contrast, after Chevron merged with Texaco in 2001, new managers were appointed in days, contributing to a smooth merger.

Disputes between HP and former Compaq staff sometimes emerged over issues such as the different approaches to compensating sales people. These issues were resolved by setting up a panel of up to six sales managers enlisted from both firms to referee the disagreements. HP also created a team to deal with combining the corporate cultures and hired consultants to document the differences. A series of workshops involving employees from both organizations were established to find ways to bridge actual or perceived differences. Teams of sales personnel from both firms were set up to standardize ways to market to common customers. Schedules were set up to ensure that agreed-upon tactics were actually implemented in a timely manner. The integration managers met with Ms. Fiorina weekly.

The results of this intense preplanning effort were evident by the end of the first year following closing. HP eliminated duplicate product lines and closed dozens of facilities. The firm cut 12,000 jobs, 2,000 more than had been planned at that point in time, from its combined 150,000 employees. HP achieved $3 billion in savings from layoffs, office closures, and consolidating its supply chain. Its original target was for savings of $2.4 billion after the first 18 months.

Despite realizing greater than anticipated cost savings, operating margins by 2004 in the PC business fell far short of expectations. This shortfall was due largely to declining selling prices and a slower than predicted recovery in PC unit sales. The failure to achieve the level of profitability forecast at this time of the acquisition contributed to the termination of Ms. Fiorina in early 2005.

Discussion Questions

1. Explain how premerger planning aided in the integration of HP and Compaq.
2. What did HP learn by studying other mergers? Give examples.
3. Cite key cultural differences between the two organizations. How were they resolved?

Integrating Supply Chains: Coty Cosmetics Integrates Unilever Cosmetics International

In mid-August 2005, Coty, one of the world’s largest cosmetics and fragrance manufacturers, acquired Unilever Cosmetics International (UCI), a subsidiary of the Unilever global conglomerate, for $800 million. Coty viewed the transaction as one in which it could become a larger player in the prestigious fragrance market of expensive perfumes. Coty believed it could reap economies of scale from having just one sales force, marketing group, and the like selling and managing the two sets of products. It hoped to retain the best people from both organizations. However, Coty’s management understood that if it were not done quickly enough, it might not realize the potential cost savings and would risk losing key personnel.

By mid-December, Coty’s IT team had just completed moving UCI’s employees from Unilever’s infrastructure to Coty’s. This involved such tedious work as switching employees from Microsoft’s Outlook to Lotus Notes. Coty’s information technology team was faced with the challenge of combining and standardizing the two firms’ supply chains, including order entry, purchasing, processing, financial, warehouse, and shipping systems. At the end of 2006, Coty’s management announced that it anticipated that the two firms would be fully integrated by June 30, 2006. From an IT perspective, the challenges were daunting. The new company’s supply chain spanned ten countries and employed four different enterprise resource planning (ERP) systems that had three warehouse systems running five major distribution facilities on two continents. ERP is an information system or process that integrates all production and related applications across an entire corporation.

On January 11–12, 2006, 25 process or function “owners,” including the heads of finance, customer service, distribution, and IT, met to create the integration plan for the firm’s disparate supply chains. In addition to the multiple distribution centers and ERP systems, operations in each country had unique processes that had to be included in the integration planning effort. For example, Italy was already using the SAP system on which Coty would eventually standardize. The largest customers there placed orders at the individual store level and expected products to be delivered to these stores. In contrast, the United Kingdom used a legacy (i.e., a highly customized, nonstandard) ERP system, and Coty’s largest customer in the United Kingdom, the Boots pharmacy chain, placed orders electronically and had them delivered to central warehouses.

Coty’s IT team, facing a very demanding schedule, knew it could not accomplish all that needed to be done in the time frame required. Therefore, it started with any system that directly affected the customer, such as sending an order to the warehouse, shipment notification, and billing. The decision to focus on “customer-facing” systems came at the expense of internal systems, such as daily management reports tracking sales and inventory levels. These systems were to be completed after the June 30, 2006, deadline imposed by senior management.

To minimize confusion, Coty created small project teams that consisted of project managers, IT directors, and external consultants. Smaller teams did not require costly overhead, like dedicated office space, and eliminated chains of command that might have prevented senior IT management from receiving timely, candid feedback on actual progress against the integration plan. The use of such teams is credited with allowing Coty’s IT department to combine sales and marketing forces as planned at the beginning of the 2007 fiscal year in July 2006. While much of the “customer-facing” work was done, many tasks remained. The IT department now had to go back and work out the details it had neglected during the previous integration effort, such as those daily reports its senior managers wanted and the real-time monitoring of transactions. By setting priorities early in the process and employing small, project-focused teams, Coty was able to integrate successfully the complex supply chains of the firms in a timely manner.

Discussion Questions

1. Do you agree with Coty management’s decision to focus on integrating “customer-facing” systems first? Explain your answer.
2. How might this emphasis on integrating “customer-facing” systems have affected the new firm’s ability to realize anticipated synergies? Be specific.
3. Discuss the advantages and disadvantages of using small project teams. Be specific.

Culture Clash Exacerbates Efforts of the Tribune Corporation to Integrate the Times Mirror Corporation

The Chicago-based Tribune Corporation owned 11 newspapers, including such flagship publications as the Chicago Tribune, the Los Angeles Times, and Newsday, as well as 25 television stations. Attempting to offset the long-term decline in newspaper readership and advertising revenue, Tribune acquired the Times Mirror (owner of the Los Angeles Times newspaper) for $8 billion in 2000. The merger combined two firms that historically had been intensely competitive and had dramatically different corporate cultures. The Tribune was famous for its emphasis on local coverage, with even its international stories having a connection to Chicago. In contrast, the L.A. Times had always maintained a strong overseas and Washington, D.C., presence, with local coverage often ceded to local suburban newspapers. To some Tribune executives, the L.A. Times was arrogant and overstaffed. To L.A. Times executives, Tribune executives seemed too focused on the “bottom line” to be considered good newspaper people.

The overarching strategy for the new company was to sell packages of newspaper and local TV advertising in the big urban markets. It soon became apparent that the strategy would be unsuccessful. Consequently, the Tribune’s management turned to aggressive cost cutting to improve profitability. The Tribune wanted to encourage centralization and cooperation among its newspapers to cut overlapping coverage and redundant jobs.

Coverage of the same stories by different newspapers owned by the Tribune added substantially to costs. After months of planning, the Tribune moved five bureaus belonging to Times Mirror papers (including the L.A. Times) to the same location as its four other bureaus in Washington, D.C. L.A. Times’ staffers objected strenuously to the move, saying that their stories needed to be tailored to individual markets and they did not want to share reporters with local newspapers. As a result of the consolidation, the Tribune’s newspapers shared as much as 40 percent of the content from Washington, D.C., among the papers in 2006, compared to as little as 8 percent in 2000. Such changes allowed for significant staffing reductions.

In trying to achieve cost savings, the firm ran aground in a culture war. Historically, the Times Mirror, unlike the Tribune, had operated its newspapers more as a loose confederation of separate newspapers. Moreover, the Tribune wanted more local focus, while the L.A. Times wanted to retain its national and international presence. The controversy came to a head when the L.A. Times’ editor was forced out in late 2006.

Many newspaper stocks, including the Tribune, had lost more than half of their value between 2004 and 2006. The long-term decline in readership within the Tribune appears to have been exacerbated by the internal culture clash. As a result, the Chandler Trusts, Tribune’s largest shareholder, put pressure on the firm to boost shareholder value. In September, the Tribune announced that it wanted to sell the entire newspaper; however, by November, after receiving bids that were a fraction of what had been paid to acquire the newspaper, it was willing to sell parts of the firm. The Tribune was taken private by legendary investor Sam Zell in 2007 and later went into bankruptcy in 2009, a victim of the recession and its bone-crushing debt load. See Case Study 13.4 for more details.

Discussion Questions

1. Why do you believe the Tribune thought it could overcome the substantial cultural differences between itself and the Times Mirror Corporation? Be specific.
2. 2. What would you have done differently following closing to overcome the cultural challenges faced by the Tribune? Be specific.

Daimler Acquires Chrysler—Anatomy of a Cross-Border Transaction

The combination of Chrysler and Daimler created the third largest auto manufacturer in the world, with more than 428,000 employees worldwide. Conceptually, the strategic fit seemed obvious. German engineering in the automotive industry was highly regarded and could be used to help Chrysler upgrade both its product quality and production process. In contrast, Chrysler had a much better track record than Daimler in getting products to market rapidly. Daimler’s distribution network in Europe would give Chrysler products better access to European markets; Chrysler could provide parts and service support for Mercedes-Benz in the United States. With greater financial strength, the combined companies would be better able to make inroads into Asian and South American markets.

Daimler’s product markets were viewed as mature, and Chrysler was under pressure from escalating R&D costs and retooling demands in the wake of rapidly changing technology. Both companies watched with concern the growing excess capacity of the worldwide automotive manufacturing industry. Daimler and Chrysler had been in discussions about doing something together for some time. They initiated discussions about creating a joint venture to expand into Asian and South American markets, where both companies had a limited presence. Despite the termination of these discussions as a result of disagreement over responsibilities, talks were renewed in February 1998. Both companies shared the same sense of urgency about their vulnerability to companies such as Toyota and Volkswagen. The transaction was completed in April 1998 for $36 billion.

Enjoying a robust auto market, starry-eyed executives were touting how the two firms were going to save billions by using common parts in future cars and trucks and by sharing research and technology. In a press conference to announce the merger, Jurgen Schrempp, CEO of DaimlerChrysler, described the merger as highly complementary in terms of product offerings and the geographic location of many of the firms’ manufacturing operations. It also was described to the press as a merger of equals (Tierney, 2000). On the surface, it all looked so easy.

The limitations of cultural differences became apparent during efforts to integrate the two companies. Daimler had been run as a conglomerate, in contrast to Chrysler’s highly centralized operations. Daimler managers were accustomed to lengthy reports and meetings to review the reports. Under Schrempp’s direction, many top management positions in Chrysler went to Germans. Only a few former Chrysler executives reported directly to Schrempp. Made rich by the merger, the potential for a loss of American managers within Chrysler was high. Chrysler managers were accustomed to a higher degree of independence than their German counterparts. Mercedes dealers in the United States balked at the thought of Chrysler’s trucks still sporting the old Mopar logo delivering parts to their dealerships. All the trucks had to be repainted.

Charged with the task of finding cost savings, the integration team identified a list of hundreds of opportunities, offering billions of dollars in savings. For example, Mercedes dropped its plans to develop a battery-powered car in favor of Chrysler’s electric minivan. The finance and purchasing departments were combined worldwide. This would enable the combined company to take advantage of savings on bulk purchases of commodity products such as steel, aluminum, and glass. In addition, inventories could be managed more efficiently, because surplus components purchased in one area could be shipped to other facilities in need of such parts. Long-term supply contracts and the dispersal of much of the purchasing operations to the plant level meant that it could take as long as 5 years to fully integrate the purchasing department.

The time required to integrate the manufacturing operations could be significantly longer, because both Daimler and Chrysler had designed their operations differently and are subject to different union work rules. Changing manufacturing processes required renegotiating union agreements as the multiyear contracts expired. All of that had to take place without causing product quality to suffer. To facilitate this process, Mercedes issued very specific guidelines for each car brand pertaining to R&D, purchasing, manufacturing, and marketing.

Although certainly not all of DaimlerChrysler’s woes can be blamed on the merger, it clearly accentuated problems associated with the cyclical economic slowdown during 2001 and the stiffened competition from Japanese automakers. The firm’s top management has reacted, perhaps somewhat belatedly to the downturn, by slashing production and eliminating unsuccessful models. Moreover, the firm has pared its product development budget from $48 billion to $36 billion and eliminated more than 26,000 jobs, or 20% of the firm’s workforce, by early 2002. Six plants in Detroit, Mexico, Argentina, and Brazil were closed by the end of 2002. The firm also cut sharply the number of Chrysler. car dealerships. Despite the aggressive cost cutting, Chrysler reported a $2 billion operating loss in 2003 and a $400 million loss in 2004.

While Schrempp had promised a swift integration and a world-spanning company that would dominate the industry, five years later new products have failed to pull Chrysler out of a tailspin. Moreover, DaimlerChrysler’s domination has not extended beyond the luxury car market, a market they dominated before the acquisition. The market capitalization of DaimlerChrysler, at $38 billion at the end of 2004, was well below the German auto maker’s $47 billion market cap before the transaction.

With the benefit of hindsight, it is possible to note a number of missteps DaimlerChrysler has made that are likely to haunt the firm for years to come. These include paying too much for some parts, not updating some vehicle models sooner, falling to offer more high-margin vehicles that could help ease current financial strains, not developing enough interesting vehicles for future production, and failing to be completely honest with Chrysler employees. Although Daimler managed to take costs out, it also managed to alienate the workforce.

Discussion Questions:

1. Identify ways in which the merger combined companies with complementary skills and resources?

Germany’s world-renowned reputation in engineering could be employed to raise the overall quality of Chrysler products, while Chrysler’s project management skills could be used to shorten the new product introduction cycle. In addition, Daimler’s distribution network in Europe could provide access to the European market for Chrysler products. Chrysler dealerships could be used to service Daimler cars in the United States. Finally, greater access to capital markets and the combined operating cash flow of the two companies could give Daimler-Chrysler the financial strength to build assembly plants and develop distribution networks in Asia.

1. What are the major cultural differences between Daimler and Chrysler?

Daimler is largely a conglomerate in which management is decentralized. In contrast, Chrysler’s management and decision-making process tended to be highly centralized. Daimler, like many European companies, tended to be very detail-oriented. The replacement of key Chrysler managers by Daimler managers may have left many Chrysler managers feeling alienated. The small number of former Chrysler managers reporting directly to the top may have added to a sense of powerlessness. Differences in customs and habits may also have contributed to poor communications.

1. What were the principal risks to the merger?

The risks to the merger included the loss of key Chrysler operating managers, who were enriched by the merger, and a loss of corporate continuity. Moreover, the lengthy time period required to integrate manufacturing operations and purchasing makes the recovery of the premium paid for Chrysler that much more difficult.

1. Why might it take so long to integrate manufacturing operations and certain functions such as purchasing?

Changing manufacturing operations require changing union work rules, which are set by contract. Such rules could only be re-negotiated when current contracts covering the plants expire. Before any significant changes could be made, Daimler-Chrysler would have to inventory/catalogue equipment and procedures by plant, benchmark performance, identify best practices, and convince workers at the plant level to change their methods. Purchasing represented both a significant opportunity and major challenge for Daimler-Chrysler. Spending on purchased materials for automotive companies represents a major portion of their total cost of production. Therefore, opportunities to buy in bulk offer substantial cost savings. However, integrating purchasing, which is often dispersed across various countries or even plants, could only be done as contracts with existing vendors expire.

5, How might Daimler have better managed the postmerger integration?

The postmerger integration period could have been better managed if Daimler had better integrated Chrysler managers into integration teams charged with melding the operations of the two firms together. Moreover, while Daimler appeared on the surface to recognize that the cultures of the firms were quite different, it seemed to be unwilling to be sensitive to retaining key managers and employees. Finally, Daimler fed a sense of mistrust between the Daimler and Chrysler employees that militated against cooperation by not being forthright in their communication with Chrysler employees. The merger was initially billed as a merger of equals. Within a short period, it was clear that this had never been the intention of Daimler management

M&A Gets Out of Hand at Cisco

Cisco Systems, the internet infrastructure behemoth, provides the hardware and software to support efficient traffic flow over the internet. Between 1993 and 2000, Cisco completed 70 acquisitions using its highflying stock as its acquisition currency. With engineering talent in short supply and a dramatic compression in product life cycles, Cisco turned to acquisitions to expand existing product lines and to enter new businesses. The firm’s track record during this period in acquiring and absorbing these acquisitions was impressive. In fiscal year 1999, Cisco acquired 10 companies. During the same period, its sales and operating profits soared by 44% and 55%, respectively. In view of its pledge not to layoff any employees of the target companies, its turnover rate among employees acquired through acquisition was 2.1%, versus an average of 20% for other software and hardware companies.

Cisco’s strategy for acquiring companies was to evaluate its targets’ technologies, financial performance, and management talent with a focus on ease of integrating the target into Cisco’s operations. Cisco’s strategy was sometimes referred to as an R&D strategy in that it sought to acquire firms with leading edge technologies that could be easily adapted to Cisco’s current product lines or used to expand it product offering. In this manner, its acquisition strategy augmented internal R&D spending. Cisco attempted to use its operating cash flow to fund development of current technologies and its lofty stock price to acquire future technologies. Cisco targeted small companies having a viable commercial product or technology. Cisco believed that larger, more mature companies tended to be difficult to integrate, due to their entrenched beliefs about technologies, hardware and software solutions.

The frequency with which Cisco was making acquisitions during the last half of the 1990s caused the firm to “institutionalize” the way in which it integrated acquired companies. The integration process was tailored for each acquired company and was implemented by an integration team of 12 professionals. Newly acquired employees received an information packet including descriptions of Cisco’s business strategy, organizational structure, benefits, a contact sheet if further information was required, and an explanation of the strategic importance of the acquired firm to Cisco. On the day the acquisition was announced, teams of Cisco human resources people would travel to the acquired firm’s headquarters and meet with small groups of employees to answer questions.

Working with the acquired firm’s management, integration team members would help place new employees within Cisco’s workforce. Generally, product, engineering, and marketing groups were kept independent, whereas sales and manufacturing functions were merged into existing Cisco departments. Cisco payroll and benefits systems were updated to reflect information about the new employees, who were quickly given access to Cisco’s online employee information systems. Cisco also offered customized orientation programs intended to educate managers about Cisco’s hiring practices, sales people about Cisco’s products, and engineers about the firm’s development process. The entire integration process generally was completed in 4–6 weeks. This lightning-fast pace was largely the result of Cisco’s tendency to purchase small, highly complementary companies; to leave much of the acquired firm’s infrastructure in place; and to dedicate a staff of human resource and business development people to facilitate the process (Cisco Systems, 1999; Goldblatt, 1999).

Cisco was unable to avoid the devastating effects of the explosion of the dot.com bubble and the 2001–2002 recession in the United States. Corporate technology buyers, who used Cisco’s high-end equipment, stopped making purchases because of economic uncertainty. Consequently, Cisco was forced to repudiate its no-layoff pledge and announced a workforce reduction of 8500, about 20% of its total employees, in early 2001. Despite its concerted effort to retain key employees from previous acquisitions, Cisco’s turnover began to soar. Companies that had been acquired at highly inflated premiums during the late 1990s lost much of their value as the loss of key talent delayed new product launches.

By mid-2001, the firm had announced inventory and acquisition-related write-downs of more than $2.5 billion. A precipitous drop in its share price made growth through acquisition much less attractive than during the late 1990s, when its stock traded at lofty price-to-earnings ratios. Thus, Cisco was forced to abandon its previous strategy of growth through acquisition to one emphasizing improvement in its internal operations. Acquisitions tumbled from 23 in 2000 to 2 in 2001. Whereas in the past, Cisco’s acquisitions appeared to have been haphazard, in mid-2003 Cisco set up an investment review board that analyzes investment proposals, including acquisitions, before they can be implemented. Besides making sure the proposed deal makes sense for the overall company and determining the ease with which it can be integrated, the board creates detailed financial projections and the deal’s sponsor must be willing to commit to sales and earnings targets.

Discussion Questions:

1. Describe how Cisco “institutionalized” the integration process. What are the advantages and disadvantages to the approach adopted by Cisco?

Answer: Cisco focused on acquisitions that were highly complementary to its existing operations. As such, the processes and procedures for integrating each acquisition could be standardized. Cisco created a group at the corporate level whose primary responsibility was to acquire and integrate the businesses following a standardized format. Presumably, the group’s ability to integrate effectively new acquisitions improved with experience.

1. Why did Cisco have a “no layoff” policy? How did this contribute to maintaining or increasing the

value of the companies it acquired?

Answer: Cisco’s no layoff policy made sense during the Internet boom when it was very difficult to acquire and retain technical people. However, when the market for their products softened the no layoff policy limited the firm’s ability to adjust its cost. Moreover, when they finally had to lay employees off it created serious mistrust of the firm among employees.

1. What evidence do you have that the high price-to-earnings ratio associated with Cisco’s stock during the late 1990s may have caused the firm to overpay for many of its acquisitions? How might overpayment have complicated the integration process at Cisco?

Answer: Cisco made many of its acquisition when its stock was trading at lofty multiples, well above other firms in its industry. It is probable that the stock was overvalued causing the firm to offer highly attractive prices to potential targets to ensure a takeover. In doing so, the firm issued more shares than might have been necessary had they been more prudent. The overhang of shares outstanding exacerbated the decline in EPS in subsequent years.

Case Corporation Loses Sight of Customer Needs

in Integrating New Holland Corporation

Farm implement manufacturer Case Corporation acquired New Holland Corporation in a $4.6 billion transaction in 1999. Overnight, its CEO, Jean-Pierre Rosso, had engineered a deal that put the combined firms, with $11 billion in annual revenue, in second place in the agricultural equipment industry just behind industry leader John Deere. The new firm was named CNH Global (CNH). Although Rosso proved adept at negotiating and closing a substantial deal for his firm, he was less agile in meeting customer needs during the protracted integration period. CNH has become a poster child of what can happen when managers become so preoccupied with the details of combining two big operations that they neglect external issues such as the economy and competition. Since the merger in November 1999, CNH began losing market share to John Deere and other rivals across virtually all of its product lines.

Rosso remained focused on negotiating with antitrust officials about what it would take to get regulatory approval. Once achieved, CNH was slow to complete the last of its asset sales as required under the consent decree with the FTC. The last divestiture was not completed until late January 2001, more than 20 months after the deal had been announced. This delay forced Rosso to postpone cost cutting and to slow their new product entries. This spooked farmers and dealers who could not get the firm to commit to telling them which products would be discontinued and which the firm would continue to support with parts and service. Fearful that CNH would discontinue duplicate Case and New Holland products, farmers and equipment dealers switched brands. The result was that John Deere became more dominant than ever. CNH was slow to reassure customers with tangible actions and to introduce new products competitive with Deere. This gave Deere the opportunity to fill the vacuum in the marketplace.

The integration was deemed to have been completed a full four years after closing. As a sign of how painful the integration had been, CNH was laying workers off as Deere was hiring to keep up with the strong demand for its products. Deere also appeared to be ahead in moving toward common global platforms and parts to take fuller advantage of economies of scale.

Discussion Questions:

1. Why is rapid integration important? Illustrate with examples from the case study.

Answer: Businesses should be integrated rapidly and intelligently to minimize customer attrition, loss of key employees to competitors, reduced product/service quality, deteriorating customer service and to maximize the acquirer’s ability to earn back any premium paid for the target. By being slow to alert New Holland’s former customers about planned new product entries, Case encouraged customer defection to Deere.

1. What could CNH have done differently to slow or reverse its loss of market share?

Answer: Case should have made decisions more rapidly and exhibited the ability to multitask. By focusing on negotiating with the regulators, they were slow to make critical decisions and to communicate effectively with all the firm’s stakeholders.

Exxon-Mobil: A Study in Cost Cutting

Having obtained access to more detailed information following consummation of the merger, Exxon-Mobil announced dramatic revisions in its estimates of cost savings. The world’s largest publicly owned oil company would cut almost 16,000 jobs by the end of 2002. This was an increase from the 9000 cuts estimated when the merger was first announced in December 1998. Of the total, 6000 would come from early retirement. Estimated annual savings reached $3.8 billion by 2003, up by more than $1 billion from when the merger originally was announced. As time passed, the companies seemed to have become a highly focused, smooth-running machine remarkably efficient at discovering, refining, and marketing oil and gas. An indication of this is the fact that the firm spent less per barrel to find oil and gas in 2003 than at almost any time in history. With revenues of $210 billion, Exxon-Mobil surged to the top of the Fortune 500 in 2004.

Discussion Question:

1. In your judgment, are acquirers more likely to under- or overestimate anticipated cost savings?

Explain your answer.

Answer: Acquirers are more prone to overestimate both the amount of synergies and under-

estimate the time and money required to realize synergies. This conclusion is suggested by the

studies that show that buyers often tend to overpay for acquisitions. This overpayment is often

justified by overstating synergies.

Albertson’s Acquires American Stores—

Underestimating the Costs of Integration

In 1999, Albertson’s acquired American Stores for $12.5 billion, making it the nation’s second largest supermarket chain, with more than 1000 stores. The corporate marriage stumbled almost immediately. Escalating integration costs resulted in a sharp downward revision of its fiscal year 2000 profits. In the quarter ended October 28, 1999, operating profits fell 15% to $185 million, despite an increase in sales of 1.6% to $8.98 billion. Albertson’s proceeded to update the Lucky supermarket stores that it had acquired in California and to combine the distribution operations of the two supermarket chains. It appears that Albertson’s substantially underestimated the complexity of integrating an acquisition of this magnitude. Albertson’s spent about $90 million before taxes to convert more than 400 stores to its information and distribution systems as well as to change the name to Albertson’s. By the end of 1999, Albertson’s stock had lost more than one-half of its value (Bloomberg.com, November 1, 1999).

Discussion Questions:

1. In your judgment, do you think acquirers’ commonly (albeit not deliberately) understate integration costs? Why or why not?

Answer: Such expenses are commonly understating when the acquirer is buying an unrelated business. In such circumstances, the dollar outlay and the amount of time required to complete integration often is understated.

1. Cite examples of expenses you believe are commonly incurred in integrating target companies.

Answer: Common integration-related expenses include the following: severance, retraining, buying out leases, closure costs, merging IT centers, inventory and receivables write-downs, maintenance expenses deferred by the seller, employee relocation expenses, advertising and signage expenses, and public relations expenditures.

Overcoming Culture Clash:

Allianz AG Buys Pimco Advisors LP

On November 7, 1999, Allianz AG, the leading German insurance conglomerate, acquired Pimco Advisors LP for $3.3 billion. The Pimco acquisition boosts assets under management at Allianz from $400 billion to $650 billion, making it the sixth largest money manager in the world.

The cultural divide separating the two firms represented a potentially daunting challenge. Allianz’s management was well aware that firms distracted by culture clashes and the morale problems and mistrust they breed are less likely to realize the synergies and savings that caused them to acquire the company in the first place. Allianz was acutely aware of the potential problems as a result of difficulties they had experienced following the acquisition of Firemen’s Fund, a large U.S.-based property–casualty company.

A major motivation for the acquisition was to obtain the well-known skills of the elite Pimco money managers to broaden Allianz’s financial services product offering. Although retention bonuses can buy loyalty in the short run, employees of the acquired firm generally need much more than money in the long term. Pimco’s money managers stated publicly that they wanted Allianz to let them operate independently, the way Pimco existed under their former parent, Pacific Mutual Life Insurance Company. Allianz had decided not only to run Pimco as an independent subsidiary but also to move $100 billion of Allianz’s assets to Pimco. Bill Gross, Pimco’s legendary bond trader, and other top Pimco money managers, now collect about one-fourth of their compensation in the form of Allianz stock. Moreover, most of the top managers have been asked to sign long-term employment contracts and have received retention bonuses.

Joachim Faber, chief of money management at Allianz, played an essential role in smoothing over cultural differences. Led by Faber, top Allianz executives had been visiting Pimco for months and having quiet dinners with top Pimco fixed income investment officials and their families. The intent of these intimate meetings was to reassure these officials that their operation would remain independent under Allianz’s ownership.

Discussion Questions:

1. How did Allianz attempt to retain key employees? In the short run? In the long run?

Answer: In short-run, Allianz used retention bonuses to discourage the defection of key employees. In the long-run, Allianz encouraged loyalty on the part of the Pimco employees by keeping the business separate and letting them operate as they had prior to the acquisition. In addition, key employees were asked to sign long-term employment agreements. Pimco money managers also receive a large portion of their total compensation in Allianz stock. In a vote of confidence in Pimco, Allianz transferred the investment portfolio they had been managing to Pimco.

1. How did the potential for culture clash affect the way Alliance acquired Pimco?

Answer: Top Allianz managers spent months prior to the acquisition trying to build personal

relationships with key Pimco employees. Allianz recognized the importance of building trust.

1. What else could Allianz have done to minimize potential culture clash? Be specific.

Answer: Allianz may have benefiting from asking certain Pimco money managers to accept temporary assignments with the parent. Likewise, Allianz employees could have taken temporary positions with Pimco. This relationship building could accelerate the integration of the disparate corporate cultures.

Avoiding the Merger Blues: American Airlines Integrates TWA

Trans World Airlines (TWA) had been tottering on the brink of bankruptcy for several years, jeopardizing a number of jobs and the communities in which they are located. Despite concerns about increased concentration, regulators approved American’s proposed buyout of TWA in 2000 largely on the basis of the “failing company doctrine.” This doctrine suggested that two companies should be allowed to merge despite an increase in market concentration if one of the firms can be saved from liquidation.

American, now the world’s largest airline, has struggled to assimilate such smaller acquisitions as AirCal in 1987 and Reno Air in 1998. Now, in trying to meld together two major carriers with very different and deeply ingrained cultures, a combined workforce of 113,000 and 900 jets serving 300 cities, American faced even bigger challenges. For example, because switches and circuit breakers are in different locations in TWA’s cockpits than in American’s, the combined airlines must spend millions of dollars to rearrange cockpit gear and to train pilots how to adjust to the differences. TWA’s planes also are on different maintenance schedules than American’s jets. For American to see any savings from combining maintenance operations, it gradually had to synchronize those schedules. Moreover, TWA’s workers had to be educated in American’s business methods, and the carrier’s reservations had to be transferred to American’s computer systems. Planes had to be repainted, and seats had to be rearranged (McCartney, 2001).

Combining airline operations always has proved to be a huge task. American has studied the problems that plagued other airline mergers, such as Northwest, which moved too quickly to integrate Republic Airlines in 1986. This integration proved to be one of the most turbulent in history. The computers failed on the first day of merged operations. Angry workers vandalized ground equipment. For 6 months, flights were delayed and crews did not know where to find their planes. Passenger suitcases were misrouted. Former Republic pilots complained that they were being demoted in favor of Northwest pilots. Friction between the two groups of pilots continued for years. In contrast, American adopted a more moderately paced approach as a result of the enormity and complexity of the tasks involved in putting the two airlines together. The model they followed was Delta Airline’s acquisition of Western Airlines in 1986. Delta succeeded by methodically addressing every issue, although the mergers were far less complex because they involved merging far fewer computerized systems.

Even Delta had its problems, however. In 1991, Delta purchased Pan American World Airways’ European operations. Pan Am’s international staff had little in common with Delta’s largely domestic-minded workforce, creating a tremendous cultural divide in terms of how the combined operations should be managed. In response to the 1991–1992 recession, Delta scaled back some routes, cut thousands of jobs, and reduced pay and benefits for workers who remained..

Before closing, American had set up an integration management team of 12 managers, six each from American and TWA. An operations czar, who was to become the vice chair of the board of the new company, directed the team. The group met daily by phone for as long as 2 hours, coordinating all merger-related initiatives. American set aside a special server to log the team’s decisions. The team concluded that the two lynchpins to a successful integration process were successfully resolving labor problems and meshing the different computer systems. To ease the transition, William Compton, TWA’s CEO, agreed to stay on with the new company through the transition period as president of the TWA operations.

The day after closing the team empowered 40 department managers at each airline to get involved. Their tasks included replacing TWA’s long-term airport leases with short-term ones, combining some cargo operations, changing over the automatic deposits of TWA employees’ paychecks, and implementing American’s environmental response program at TWA in case of fuel spills. Work teams, consisting of both American and TWA managers, identified more than 10,000 projects that must be undertaken before the two airlines can be fully integrated.

Some immediate cost savings were realized as American was able to negotiate new lease rates on TWA jets that are $200 million a year less than what TWA was paying. These savings were a result of the increased credit rating of the combined companies. However, other cost savings were expected to be modest during the 12 months following closing as the two airlines were operated separately. TWA’s union workers, who would have lost their jobs had TWA shut down, have been largely supportive of the merger. American has won an agreement from its own pilots’ union on a plan to integrate the carriers’ cockpit crews. Seniority issues proved to be a major hurdle. Getting the mechanics’ and flight attendants’ unions on board required substantial effort. All of TWA’s licenses had to be switched to American. These ranged from the Federal Aviation Administration operating certificate to TWA’s liquor license in all the states.

Discussion Questions:

1. In your opinion, what are the advantages and disadvantages of moving to integrate operations

quickly? What are the advantages and disadvantages of moving more slowly and deliberately?

Answer: Quick integration minimizes employee turnover, customer and supplier attrition, and adds to the acquirer’s ability to earn back any premium paid for the target. However, some functions which directly touch the customer should be done more slowly since failure to smoothly integrate these functions can be very disruptive to the customer. Such functions include customer service call and data centers.

1. Why did American choose to use managers from both airlines to direct the integration of the

two companies? What are the specific benefits in doing so?

Answer: Choosing managers from both firms enables the use of the most competent managers. It also helps to integrate disparate cultures by building trust and familiarity among managers from both firms.

1. How did the interests of the various stakeholders to the merger affect the complexity of the

integration process?

Answer: The integration was made more challenging by the need to get acceptance by powerful employee unions.

The Travelers and Citicorp Integration Experience

Promoted as a merger of equals, the merger of Travelers and Citicorp to form Citigroup illustrates many of the problems encountered during postmerger integration. At $73 billion, the merger between Travelers and Citicorp was the second largest merger in 1998 and is an excellent example of how integrating two businesses can be far more daunting than consummating the transaction. Their experience demonstrates how everything can be going smoothly in most of the businesses being integrated, except for one, and how this single business can sop up all of management’s time and attention to correct its problems. In some respects, it highlights the ultimate challenge of every major integration effort: getting people to work together. It also spotlights the complexity of managing large, intricate businesses when authority at the top is divided among several managers.

The strategic rationale for the merger relied heavily on cross-selling the financial services products of both corporations to the other’s customers. The combination would create a financial services giant capable of making loans, accepting deposits, selling mutual funds, underwriting securities, selling insurance, and dispensing financial planning advice. Citicorp had relationships with thousands of companies around the world. In contrast, Travelers’ Salomon Smith Barney unit dealt with relatively few companies. It was believed that Salomon could expand its underwriting and investment banking business dramatically by having access to the much larger Citicorp commercial customer base. Moreover, Citicorp lending officers, who frequently had access only to midlevel corporate executives at companies within their customer base, would have access to more senior executives as a result of Salomon’s investment banking relationships.

Although the characteristics of the two businesses seemed to be complementary, motivating all parties to cooperate proved a major challenge. Because of the combined firm’s co-CEO arrangement, the lack of clearly delineated authority exhausted management time and attention without resolving major integration issues. Some decisions proved to be relatively easy. Others were not. Citicorp, in stark contrast to Travelers, was known for being highly bureaucratic with marketing, credit, and finance departments at the global, North American, and business unit levels. North American departments were eliminated quickly. Salomon was highly regarded in the fixed income security area, so Citicorp’s fixed income operations were folded into Salomon. Citicorp received Salomon’s foreign exchange trading operations because of their pre-merger reputation in this business. However, both the Salomon and Citicorp derivatives business tended to overlap and compete for the same customers. Each business unit within Travelers and Citicorp had a tendency to believe they “owned” the relationship with their customers and were hesitant to introduce others that might assume control over this relationship. Pay was also an issue, as investment banker salaries in Salomon Smith Barney tended to dwarf those of Citicorp middle-level managers. When it came time to cut costs, issues arose around who would be terminated.

Citicorp was organized along three major product areas: global corporate business, global consumer business, and asset management. The merged companies’ management structure consisted of three executives in the global corporate business area and two in each of the other major product areas. Each area contained senior managers from both companies. Moreover, each area reported to the co-chairs and CEOs John Reed and Sanford Weill, former CEOs of Citicorp and Travelers, respectively. Of the three major product areas, the integration of two was progressing well, reflecting the collegial atmosphere of the top managers in both areas. However, the global business area was well behind schedule, beset by major riffs among the three top managers. Travelers’ corporate culture was characterized as strongly focused on the bottom line, with a lean corporate overhead structure and a strong predisposition to impose its style on the Citicorp culture. In contrast, Citicorp, under John Reed, tended to be more focused on the strategic vision of the new company rather than on day-to-day operations.

The organizational structure coupled with personal differences among certain key managers ultimately resulted in the termination of James Dimon, who had been a star as president of Travelers before the merger. On July 28, 1999, the co-chair arrangement was dissolved. Sanford Weill assumed responsibility for the firm’s operating businesses and financial function, and John Reed became the focal point for the company’s internet, advanced development, technology, human resources, and legal functions. This change in organizational structure was intended to help clarify lines of authority and to overcome some of the obstacles in managing a large and complex set of businesses that result from split decision-making authority. On February 28, 2000, John Reed formally retired.

Although the power sharing arrangement may have been necessary to get the deal done, Reed’s leaving made it easier for Weill to manage the business. The co-CEO arrangement had contributed to an extended period of indecision, resulting in part to their widely divergent views. Reed wanted to support Citibank’s Internet efforts with substantial and sustained investment, whereas the more bottom-line-oriented Weill wanted to contain costs.

With its $112 billion in annual revenue in 2000, Citigroup ranked sixth on the Fortune 500 list. Its $13.5 billion in profit was second only to Exxon-Mobil’s $17.7 billion. The combination of Salomon Smith Barney’s investment bankers and Citibank’s commercial bankers is working very effectively. In a year-end 2000 poll by Fortune magazine of the Most Admired U.S. companies, Citigroup was the clear winner. Among the 600 companies judged by a poll of executives, directors, and securities analysts, it ranked first for using its assets wisely and for long-term investment value (Loomis, 2001). However, this early success has taken its toll on management. Of the 15 people initially on the management committee, only five remain in addition to Weill. Among those that have left are all those that were with Citibank when the merger was consummated. Ironically, in 2004, James Dimon emerged as the head of the JP Morgan Chase powerhouse in direct competition with his former boss Sandy Weill of Citigroup.

Discussion Questions:

1. Why did Citibank and Travelers resort to a co-CEO arrangement? What are the advantages and disadvantages of such an arrangement?

Answer: The Citibank/Travelers transaction was billed as a merger of equals, i.e., one in which neither party is believed to provide a disproportionate share of anticipated synergy. The co-CEO arrangement was necessary to get support from the Citibank management team. The advantages are that they encourage cooperation from top management of the target firm in completing the transaction. However, during the post-closing period, the disadvantages become evident due to the need to generate consensus within the office of the CEO for important decisions. Moreover, the lack of clearly delineated authority exhausted management time and attention without resolving major integration issues.

1. Describe the management challenges you think may face Citigroup’s management team due to the increasing global complexity of Citigroup?

Answer: The management teams of the two firms were quite different, as were the overall corporate cultures. Citibank was widely viewed as a strong marketing and planning organization, while Travelers focused on operational efficiency and the effective implementation of business plans. Differing priorities inevitably lead to inaction as both parties promote the efficacy of their own philosophies. Action is often replaced by analysis of options.

1. Identify the key differences between Travelers’ and Citibank’s corporate cultures. Discuss ways you would resolve such differences.

Answer: Traveler’s corporate culture was characterized as strongly focused on the bottom line, with a lean corporate overhead structure and a strong predisposition to impose its style on the Citicorp culture. In contrast, Citicorp tended to be more focused on the strategic vision of the new company rather than on day-to-day operations. While these cultural differences were formidable, some progress at infusing the new combined firm’s culture with the best of both firms could be made by co-locating Traveler’s and Citibank employees were possible. Moreover, managers from each firm could be transferred laterally into similar positions to introduce new concepts, discipline, and a sense of urgency. Finally, incentive systems could be introduced to induce the desired changes in the new culture. For example, while cost cutting seemed out of place within the Citibank environment, bonuses for former Citibank managers could be made increasingly dependent on their ability to achieve certain cost savings targets.

1. In what sense is the initial divergence in Travelers’ operational orientation and Citigroup’s marketing and planning orientation an excellent justification for the merger? Explain your answer.

Answer: The core competencies of the two businesses, e.g., Citibank’s marketing and planning skills and Traveler’s operational excellence, filled voids found in each business. The different talents of each firm presented an opportunity for the new firm to develop a culture that would exploit the best of both firms in order to strengthen its overall competitiveness.

1. One justification for the merger was the cross-selling opportunities it would provide. Comment on the challenges that might be involved in making such a marketing strategy work.

Answer: Cross-selling is a conceptually simple strategy, but it is often ferociously difficult to implement. Marketing and sales people tend to sell that with which they are most comfortable. Consequently, even if they are provided with a new array of product to offer their customers, they may be very slow in doing so because it is simply easier to continue to sell what they have been selling. Furthermore, sales people must be trained in how to sell the new products. This takes both time and money. Finally, new incentive systems may be required to induce the sales forces of each firm to sell the other firm’s products aggressively.

Promises to PeopleSoft’s Customers Complicate Oracle’s Integration Efforts

When Oracle first announced its bid for PeopleSoft in mid-2003, the firm indicated that it planned to stop selling PeopleSoft’s existing software programs and halt any additions to its product lines. This would result in the termination of much of PeopleSoft’s engineering, sales, and support staff. Oracle indicated that it was more interested in PeopleSoft’s customer list than its technology. PeopleSoft earned sizeable profit margins on its software maintenance contracts, under which customers pay for product updates, fixing software errors, and other forms of product support. Maintenance fees represented an annuity stream that could improve profitability even when new product sales are listless. However, PeopleSoft’s customers worried that they would have to go through the costly and time-consuming process of switching software. To win customer support for the merger and to avoid triggering $2 billion in guarantees PeopleSoft had offered its customers in the event Oracle failed to support its products, Oracle had to change dramatically its position over the next 18 months.

One day after reaching agreement with the PeopleSoft board, Oracle announced it would release a new version of PeopleSoft’s products and would develop another version of J.D. Edwards’s software, which PeopleSoft had acquired in 2003. Oracle committed itself to support the acquired products even longer than PeopleSoft’s guarantees would have required. Consequently, Oracle had to maintain programs that run with database software sold by rivals such as IBM. Oracle also had to retain the bulk of PeopleSoft’s engineering staff and sales and customer support teams.

Among the biggest beneficiaries of the protracted takeover battle was German software giant SAP. SAP was successful in winning customers uncomfortable about dealing with either Oracle or PeopleSoft. SAP claimed that its worldwide market share had grown from 51 percent in mid-2003 to 56 percent by late 2004. SAP took advantage of the highly public hostile takeover by using sales representatives, email, and an international print advertising campaign to target PeopleSoft customers. The firm touted its reputation for maintaining the highest quality of support and service for its products.

Discussion Questions

1. How did the commitments Oracle made to PeopleSoft’s customers have affected its ability to realize anticipated synergies? Be specific.

Answer: Such commitments prevented Oracle from cutting duplicate positions at PeopleSoft in order to realize cost savings in a timely fashion. Moreover, Oracle had to maintain investment levels to ensure maintain appropriate customer support and maintenance operations.

1. Explain why Oracle’s willingness to pay such a high premium for PeopleSoft and its willingness to change its position on supporting PeopleSoft products and retaining the firm’s employees may have had a negative impact on Oracle shareholders. Be specific.

Answer: The inability to realize savings immediately limited Oracle’s ability to earn back the large premium paid for the firm, potentially resulting in an inability to earn the firm’s cost of capital.

Chapter 7: Merger and Acquisition Cash Flow Valuation Basics

Examination Questions and Answers

True and False Questions: Answer true or false to the following questions: (Circle True or False)

1. In calculating the weighted average cost of capital, the weights should be estimated using the market value of the target firm’s debt and equity. True or False

Answer: True

1. A beta coefficient is a measure of a firm’s diversifiable risk. True or False

Answer: False

1. In the absence of debt, the unlevered beta measures the volatility of the firm’s financial return to changes in the general stock market’s overall return. True or False

Answer: True

1. Free cash flow to the firm is calculated before debt and taxes. True or False

Answer: False

1. Free cash flow to equity is calculated using operating income. True or False

Answer: False

1. If free cash flow to the firm is expected to remain at $10 million indefinitely and the firm’s cost of equity is .10, the present value of the firm is $100 million. True or False

Answer: False

1. The constant growth valuation model is primarily applicable to firms in mature markets. True or False

Answer: True

1. The estimation of present value using the constant growth model involves the calculation of a terminal value. True or False

Answer: False

1. It is possible to determine the equity value of the firm if you know the present value of free cash flow to the firm and the book value of the firm’s outstanding shares. True or False

Answer: False

1. The discounted cash flow method for valuing a firm adjusts for differences in the magnitude and timing of cash flows and for risk.

True or False

Answer: True

1. The cost of equity is the minimum financial return required by investors to invest in stocks of comparable risk. True or False

Answer: True

1. The capital asset pricing model is commonly used to estimate the cost of equity. True or False

Answer: True

1. Interest payments are tax deductible to firms in the U.S. True or False

Answer: True

1. A firm’s beta is affected by the amount of debt a firm maintains relative to its equity. True or False

Answer: True

1. Free cash flow to the firm is also called enterprise cash flow. True or False

Answer: True

1. A risk-free rate of return is one for which the expected return is certain. True or False

Answer: True

1. If an investor anticipates a future cash flow stream of five or ten years, she needs to use either a five- or ten-year Treasury bond rate

as the risk-free rate. True or False

Answer: True

1. Studies show that it is generally unnecessary to adjust the capital asset pricing model for the size of the firm. True or False

Answer: False

1. The size factor used to adjust the capital asset pricing model serves as a proxy for factors such as smaller firms being subject to

higher default risk and generally being less liquid than large capitalization firms. True or False

Answer: True

1. Preferred stock exhibits some of the characteristics of long-term debt in that its dividend is generally constant and preferred

stockholders are paid before common shareholders in the event the firm is liquidated. True or False

Answer: True

1. Viewing preferred dividends as paid in perpetuity, the cost of preferred stock can be calculated as dividends per share of preferred

stock divided by the market value of the preferred stock. True or False

Answer: True

1. The weighted average cost of capital consists only of debt and equity. True or False

Answer: False

1. The after-tax cost of borrowed funds to the firm is estimated by multiplying the pretax interest rate, i, by (1 – t), where t is the

marginal tax rate for the firm. True or False

Answer: True

1. The weights used to calculate the weighted average cost of capital for a firm with common equity and debt only represent the book

value of equity and debt. True or False

Answer: False

1. The cost of capital formula can be generalized to include hybrid sources of funds available to firms such as convertible preferred

and debt. True or False

Answer: True

1. According to the capital asset pricing model, risk consists of both diversifiable and non-diversifiable components. True or False

Answer: True

1. Both public and private firms are subject to non-diversifiable risk. True or False

Answer: True

1. In the absence of debt, b measures the volatility of a firm’s financial return to changes in the general market’s overall financial

return. True or False

Answer: True

1. Net debt is defined as all of the firm’s interest bearing debt less the value of cash and marketable securities. True or False

Answer: True

1. When the firm increases its debt in direct proportion to the market value of its equity, the level of the debt is perfectly correlated

with the firm’s market value. True or False

Answer: True

1. Beta is a measure of non-diversifiable risk. True or False

Answer: True

1. Free cash flow to the firm is often called enterprise cash flow. True or False

Answer: True

1. The enterprise or free cash flow to the firm approach to valuation discounts the after-tax free cash flow available to the firm from operations at the weighted average cost of capital to obtain the enterprise value. True or False

Answer: True

1. The constant growth model is most applicable to firms in mature markets. True or False

Answer: True

1. The variable growth model would be most appropriate for valuing firms in the growth phase of their product life cycle. True or False

Answer: True

1. Growth rates can be calculated based on the historical experience of the firm or industry. True or False

Answer: True

1. Intuition suggests that the length of the high-growth period when applying the variable growth model should be shorter the greater the current growth rate of the firm’s cash flow. True or False

Answer: False

1. When cash flow is temporarily depressed due to strikes, litigation, warranty claims, or other one-time events, it is generally safe to assume that cash flow will recover in the near term. True or False

Answer: True

1. The projected cash flow of firms in highly cyclical industries can be distorted depending on where the firm is in the business cycle. True or False

Answer: True

1. The constant growth model may be used to estimate the risk premium component of the cost of equity as an alternative to relying on historical information as is done in the capital asset pricing model. True or False

Answer: True

1. Discounted cash flow and the asset-oriented valuation methods necessarily provide identical results. True or False

Answer: False

1. Investors require a minimum rate of return on an investment to compensate them for the level of perceived risk associated with that investment. True or False

Answer: True

1. The cost of equity can also be viewed as an opportunity cost. True or False

Answer: True

1. For a return to be considered risk-free over some future time period it must be free of default risk and there must not be any uncertainty about the reinvestment rate (i.e., the rate of return that can be earned at the end of the investor’s holding period).

True or False

Answer: True

1. Whether an analyst should use a short or long-term interest rate for the risk free rate in calculating the CAPM depends on when

the investor receives their future cash flows. True or False

Answer: True

1. A three-month Treasury bill rate is not free of risk for a five- or ten-year period, since interest and principal received at maturity must be reinvested at three month intervals. True or False

Answer: True

1. The market risk or equity premium refers to the additional rate of return in excess of the weighted average cost of capital that investors require to purchase a firm’s equity. True or False

Answer: False

1. Betas do not vary over time and are quite insensitive to the time period and methodology employed in their estimation. True or False

Answer: False

1. Studies show that the market risk premium is unstable, lower during periods of prosperity and higher during periods of economic slowdowns. True or False

Answer: True

1. For firms whose market value is less than $50 million, the adjustment to the CAPM in estimating the cost of equity can be as large as 2 percentage points. True or False

Answer: False

1. Assume a firm has a market value of less than $50 million and a b of 1.75. Also, assume the risk-free rates of return and equity premium are 5.0 and 5.5 percent, respectively. The firm’s cost of equity using the CAPM method adjusted for firm size is 23.8%. True or False

Answer: True

1. A firm’s credit rating is a poor measure of a firm’s default risk. True or False

Answer: False

1. For non-rated firms, the analyst may estimate the pretax cost of debt for an individual firm by comparing debt-to-equity or total capital ratios, interest coverage ratios, and operating margins with those of similar rated firms. True or False

Answer: True

1. Preferred dividends are tax deductible to U.S. corporations. True or False

Answer: False

1. The weighted average cost of capital (WACC) is the broadest measure of the firm’s cost of funds and represents the return that a firm must earn to induce investors to buy its common stock. True or False

Answer: False

1. The relationship between the overall market and a specific firm’s beta may change significantly if a large sector of stocks that make up the overall index increase or decrease substantially. True or False

Answer: True

1. The reduction in the firm’s tax liability due to the tax deductibility of interest is often referred as a tax shield. True or False

Answer: True

1. When the firm increases its debt in direct proportion to the market value of its equity, the level of the debt is perfectly correlated with the firm’s market value. Consequently, the risk associated with the tax shield (resulting from interest paid on outstanding debt) is the same as that associated with the firm. True or False

Answer: True

1. The effective tax rate is calculated from actual taxes paid based on accounting statements prepared for tax reporting purposes. True or False

Answer: True

1. Whatever the analyst chooses to do with respect to the selection of a tax rate, it is critical to use the marginal rate in calculating after-tax operating income in perpetuity. Otherwise, the implicit assumption is that taxes can be deferred indefinitely. True or False

Answer: True

Multiple Choice Questions (Circle only one alternative)

1. Which one of the following factors is not considered in calculating the firm’s cost of equity?
2. risk free rate of return
3. beta
4. interest rate on corporate debt
5. expected return on equities
6. difference between expected return on stocks and the risk free rate of return

Answer: C

1. Which one of the following factors is not considered in calculating the firm’s cost of capital?
2. cost of equity
3. interest rate on debt
4. the firm’s marginal tax rate
5. book value of debt and equity
6. the firm’s target debt to equity ratio

Answer: D

1. A firm’s leveraged beta reflects all of the following except for
2. unleveraged beta
3. the firm’s debt
4. marginal tax rate
5. the firm’s cost of equity
6. the firm’s equity

Answer: D

1. Which of the following factors is excluded from the calculation of free cash flow to the firm?
2. Principal repayments
3. Operating income
4. Depreciation
5. The change in working capital
6. Gross plant and equipment spending

Answer: A

1. Which of the following is not true about the constant growth valuation model?
2. The firm’s free cash flow is assumed to be unchanged in perpetuity
3. The firm’s free cash flow is assumed to grow at a constant rate in perpetuity
4. Free cash flow is discounted by the difference between the appropriate discount rate and the expected growth rate of cash flow.
5. The constant growth model is sometimes referred to as the Gordon Growth Model.
6. If the analyst were using free cash flow to the firm, cash flow would be discounted by the firm’s cost of capital less the expected growth rate in cash flow.

Answer: A

1. Which of the following is not true about the variable growth valuation model?
2. Assumes a high growth period followed by a stable growth period.
3. Assumes that the discount rate during the high and stable growth periods is the same.
4. Is used primarily to evaluate firms in high growth industries.
5. Involves the calculation of a terminal value.
6. The terminal value often comprises a substantial percentage of the total present value of the firm.

Answer: B

1. The cost of capital reflects all of the following except for
2. Cost of equity
3. The firm’s beta
4. The book value of the firm’s debt
5. The after-tax cost of interest paid by the firm
6. The risk free rate of return

Answer: C

1. The calculation of free cash flow to the firm includes all of the following except for

1. Net income
2. Marginal tax rate
3. Change in working capital
4. Gross plant and equipment spending
5. Depreciation

Answer: A

1. The calculation of free cash flow to equity includes all of the following except for

1. Operating income
2. Preferred dividends
3. Change in working capital
4. Gross plant and equipment spending
5. Principal repayments

Answer: A

1. All of the following are true about the marginal tax rate for the firm except for

1. The marginal tax rate in the U.S. is usually about 40%.
2. The effective tax rate is usually less than the marginal tax rate.
3. Once tax credits have been used and the ability to further defer taxes exhausted, the effective rate can exceed the

marginal rate at some point in the future.

1. It is critical to use the effective tax rate in calculating after-tax operating income in perpetuity.
2. It is critical to use the marginal rate in calculating after-tax operating income in perpetuity.

Answer: D

1. For a firm having common and preferred equity as well as debt, common equity value can be estimated in which of the following ways?

1. By subtracting the book value of debt and preferred equity from the enterprise value of the firm
2. By subtracting the market value of debt from the enterprise value of the firm
3. By subtracting the market value of debt and the market value of preferred equity from the enterprise value of the firm
4. By adding the market value of debt and preferred equity to the enterprise value of the firm
5. By adding the market value of debt and book value of preferred equity to the enterprise value of the firm

Answer: C

1. The zero growth model is a special case of what valuation model?

1. Variable growth model
2. Constant growth model
3. Delta growth model
4. Perpetuity valuation model
5. None of the above

Answer: B

1. Which of the following is true of the enterprise valuation model?

1. Discounts free cash flow to the firm by the cost of equity
2. Discounts free cash flow to the firm by the weighted average cost of capital
3. Discounts free cash flow to equity by the cost of equity
4. Discounts free cash flow to equity by the weighted average cost of capital
5. None of the above

Answer: B

1. Which of the following is true of the equity valuation model?

1. Discounts free cash flow to the firm by the weighted average cost of capital
2. Discounts free cash flow to equity by the cost of equity
3. Discounts free cash flow the firm by the cost of equity
4. Discounts free cash flow to equity by the weighted average cost of capital
5. None of the above

Answer: B

1. Which of the following is true about the variable growth model?

1. Present value equals the discounted sum of the annual forecasts of cash flow
2. Present value equals the discounted sum of the annual forecasts of cash flow plus the discounted value of the terminal value
3. Present value equals the discounted value of the next year’s cash flow grown at a constant rate in perpetuity
4. Present value equals the current year’s free cash flow discounted in perpetuity
5. None of the above

Answer: B

1. When evaluating an acquisition, you should do which of the following:
2. Ignore market values of assets and focus on book value
3. Ignore the timing of when the cash flows will be received
4. Ignore acquisition fees and transaction costs
5. Apply the discount rate that is relevant to the incremental cash flows
6. Ignore potential losses of management talent

Answer: D

1. The incremental cash flows of a merger can relate to which of the following:
2. Working capital
3. Profits
4. Capital spending
5. Income taxes
6. All of the above

Answer: E

Additional Problems/Case Studies

The Importance of Distinguishing Between Operating and Nonoperating Assets

In 2006, Verizon Communications and MCI Inc. executives completed a deal in which MCI shareholders received $6.7 billion for 100% of MCI stock. Verizon’s management argued that the deal cost their shareholders only $5.3 billion in Verizon stock, with MCI having agreed to pay its shareholders a special dividend of $1.4 billion contingent on their approval of the transaction. The $1.4 billion special dividend reduced MCI’s cash in excess of what was required to meet its normal operating cash requirements.

To understand the actual purchase price, it is necessary to distinguish between operating and nonoperating assets. Without the special dividend, the $1.4 billion in cash would have transferred automatically to Verizon as a result of the purchase of MCI’s stock. Verizon would have had to increase its purchase price by an equivalent amount to reflect the face value of this nonoperating cash asset. Consequently, the purchase price would have been $6.7 billion. With the special dividend, the excess cash transferred to Verizon was reduced by $1.4 billion, and the purchase price was $5.3 billion.

In fact, the alleged price reduction was no price reduction at all. It simply reflected Verizon’s shareholders receiving $1.4 billion less in net acquired assets. Moreover, since the $1.4 billion represents excess cash that would have been reinvested in MCI or paid out to shareholders anyway, the MCI shareholders were simply getting the cash earlier than they may have otherwise.

The Hunt for Elusive Synergy—@Home Acquires Excite

Background Information

Prior to @Home Network’s merger with Excite for $6.7 billion, Excite’s market value was about $3.5 billion. The new company combined the search engine capabilities of one of the best-known brands (at that time) on the Internet, Excite, with @Home’s agreements with 21 cable companies worldwide. @Home gains access to the nearly 17 million households that are regular users of Excite. At the time, this transaction constituted the largest merger of Internet companies ever. At the time of the transaction, the combined firms, called Excite @Home, displayed a P/E ratio in excess of 260 based on the consensus earnings estimate of $0.21 per share. The firm’s market value was $18.8 billion, 270 times sales. Investors had great expectations for the future performance of the combined firms, despite their lackluster profit performance since their inception. @Home provided interactive services to home and business users over its proprietary network, telephone company circuits, and through the cable companies’ infrastructure. Subscribers paid $39.95 per month for the service.

Assumptions

• Excite is properly valued immediately prior to announcement of the transaction.
• Annual customer service costs equal $50 per customer.
• Annual customer revenue in the form of @Home access charges and ancillary services equals $500 per customer. This assumes that declining access charges in this highly competitive environment will be offset by increases in revenue from the sale of ancillary services.
• None of the current Excite user households are current @Home customers.
• New @Home customers acquired through Excite remain @Home customers in perpetuity.
• @Home converts immediately 2 percent or 340,000 of the current 17 million Excite user households.
• @Home’s cost of capital is 20 percent during the growth period and drops to 10 percent during the slower, sustainable growth period; its combined federal and state tax rate is 40 percent.
• Capital spending equals depreciation; current assets equal current liabilities.
• FCFF from synergy increases by 15 percent annually for the next 10 years and 5 percent thereafter. Its cost of capital after the high-growth period drops to 10 percent.
• The maximum purchase price @Home should pay for Excite equals Excite’s current market price plus the synergy that results from the merger of the two businesses.

Discussion Questions

1. Use discounted cash flow (DCF) methods to determine if @Home overpaid for Excite.
2. What other assumptions might you consider in addition to those identified in the case study?
3. What are the limitations of the discounted cash flow method employed in this case?

Answers to Case Study Questions:

1. Did @Home overpay for Excite?

Answer: To answer the question of whether @Home overpaid, it is necessary to estimate the value of synergy, add this estimate to the market value of Excite, and compare the resulting sum to the $6.7 billion purchase price. Note that free cash flow to the firm in the first full year of operation following the merger equals ($500 – $50) x (1 – .4) x 340,000 or $91.8 million.

Using the variable growth model, we can calculate the present value of potential synergy (P₀) as follows:

Year: FCFF Present Value Present Value

($Millions) Interest Factor ($Millions)

1 91.8 .83 76.2

2 105.6 .69 73.3

3 121.4 .58 70.4

4 139.6 .48 67.0

5 160.6 .40 64.2

6 184.6 .33 61.8

7 212.3 .28 59.4

8 244.2 .23 56.2

9 280.8 .19 53.4

10 322.9 .16 51.7

$633.6

Terminal Value = $322.9 x (1.05) / (.10 – .05) = $6,780.90 = $1,095.5

(1.20)¹⁰ 6.19

P₀ = $633.6 + $1,095.5 = $1,729.1

Maximum purchase price for Excite (incl. present value of synergy)

$1,729.1 + $3,500.0 = $5,229.1 (vs. $6,700.0)

1. What other assumptions might you consider?

Answer: Other sources of profitable revenue such as selling additional products and services to the Excite customer base and advertising revenue could be considered. In addition, some assumption would have to be made about working capital requirements and investment in new server capacity and other support infrastructure as the subscriber base grew over time.

1. What are the limitations of the valuation methodology employed in this case?

Answer: The valuation is heavily dependent on the choice of assumptions concerning growth rates during the high growth and stable growth periods and the discount rates for each period. Almost two-thirds of the total valuation is dependent on the estimation of the residual value or the value of cash flows beyond the tenth year, which is likely to be less accurate than estimates of cash flows during the earlier years of the forecast period.

Creating a Global Luxury Hotel Chain

Fairmont Hotels & Resorts Inc. announced on January 30, 2006, that it had agreed to be acquired by Kingdom Hotels and Colony Capital in an all-cash transaction valued at $45 per share. The transaction is valued at $3.9 billion, including assumed debt. The purchase price represents a 28% premium over Fairmont’s closing price on November 4, 2005, the last day of trading when Kingdom and Colony expressed interest in Fairmont. The combination of Fairmont and Kingdom will create a luxury global hotel chain with 120 hotels in 24 countries. Discounted cash-flow analyses, including estimated synergies and terminal value, value the firm at $43.10 per share. The net asset value of Fairmont’s real estate is believed to be $46.70 per share.

Discussion Questions

1. Is it reasonable to assume that the acquirer could actually be getting the operation for “free,” since the value of the real estate per share is worth more than the purchase price per share? Explain your answer.
2. Assume the acquirer divests all of Fairmont’s hotels and real estate properties but continues to manage the hotels and properties under long-term management contracts. How would you estimate the net present value of the acquisition of Fairmont to the acquirer? Explain your answer.

Answers to Case Study Questions:

1. Is it reasonable to assume that the acquirer could actually be getting the operation for “free,” since the value of the real estate per share is worth more than the purchase price per share? Explain your answer.

Answer: The total value of the combined firms is the present value of operating cash flows including synergies and the terminal value generated by all assets and liabilities used in the operation of the business plus the present value of non-operating assets. Assuming all real estate assets are used in the operation of the business (i.e., PV of non-operating assets is zero), their value is already included in the valuation of the stock. Consequently, the buyer is paying $45 a share for the stock, which reflects the cash flows generated by all operating assets and liabilities required to operate the business. Another way of looking at this valuation is that the liquidation value of the business is as least $46.70 per share, i.e., the net asset value of the real estate. Therefore, either way the buyer seems to be paying close to the fair market value of the business and in no sense is the business being acquired for “free.”

1. Assume the acquirer divests all of Fairmont’s hotels and real estate properties but continues to manage the hotels and properties under long-term management contracts. How would you estimate the net present value of the acquisition of Fairmont to the acquirer? Explain your answer.

Answer: If the acquirer sells the hotels and properties but continues to manage them under a long-term management contract, the value of the ongoing businesses to the acquirer is the net present value of the cash flows generated under the management contract less the purchase price of the business minus the cash proceeds realized in selling the business. The purchase price (i.e., $45 per share) and the net asset value of the real estate (i.e., $46.70) essentially cancel. Consequently, the NPV of the acquisition of Fairmont to the acquirer equals the value of cash flows generated under the long-term management contracts.