Question 22.5: FAT Corporation stock is currently trading at $40 per share....
FAT Corporation stock is currently trading at $40 per share. There are 20 million shares outstanding, and the company has no debt. You are a partner in a firm that specializes in leveraged buyouts. Your analysis indicates that the management of this corporation could be improved considerably. If the managers were replaced with more capable ones, you estimate that the value of the company would increase by 50%. You decide to initiate a leveraged buyout and issue a tender offer for at least a controlling interest—50% of the outstanding shares. What is the maximum amount of value you can extract and still complete the deal?
PLAN
Currently, the value of the company is $40 \times 20 million = $800 million, and you estimate you can add an additional 50%, or $400 million. If you borrow $400 million and the tender offer succeeds, you will take control of the company and install new management. The total value of the company will increase by 50% to $1.2 billion. You will also attach the debt to the company, so the company will now have $400 million in debt.
You can then compute the value of the post-takeover equity and your gain. You can repeat this computation assuming you borrow more than $400 million and confirming that your gain does not change.
EXECUTE
The value of the equity once the deal is done is the total value minus the debt outstanding:
Total Equity = $1200 million – $400 million = $800 million
The value of the equity is the same as the premerger value. You own half the shares, which are worth $400 million, and paid nothing for them, so you have captured the value you anticipated adding to FAT.
What if you borrowed more than $400 million? Assume you were able to borrow $450 million. The value of equity after the merger would be
Total Equity = $1200 million – $450 million = $750 million
This is lower than the premerger value. Recall, however, that in the United States, existing shareholders must be offered at least the premerger price for their shares. Because existing shareholders anticipate that the share price will be lower once the deal is complete, all shareholders will tender their shares. This implies that you will have to pay $800 million for these shares, and so to complete the deal, you will have to pay $800 million – $450 million = $350 million out of your own pocket. In the end, you will own all the equity, which is worth $750 million. You paid $350 million for it, so your profit is again $400 million.
EVALUATE
In each case, the most you can gain is the $400 million in value you add by taking over FAT. Thus, you cannot extract more value than the value you add to the company by taking it over.