Shawmut National Corporation Harvard Case Solution & Analysis

Shawmut National Corporation’s Merger with Bank of Boston Corporation (A)

Q1.) Why are Shawmut and Bank of Boston considering a merger?  Does a merger make economic sense?

Shawmut National Corporation (SNC) and Bank of Boston Corporation (BKB) are in financial distress and due to increasing charge-offs on non-performing loans both banks are under pressure by the regularity bodies i.e. Comptroller of the Currency and the Federal Reserve, to overcome the losses. One of the ways to overcome loan losses suggested by regulatory bodies is to merge with other bank.

Moreover, the merger between SNC and BKB will create largest holding company in New England and will result in remarkable cost saving from layoffs, closing of unwanted branches, and back office consolidation (i.e. sharing of services within the group).

Additionally, the recently passed inter-state banking legislation and proposed nationwide banking legislation have threatened the independence of regional banks; therefore the regional banks are expanding their size by aggressive lending and through acquisitions. Consequently, SNC and BKB are trying to expand its size through merger and to become the largest bank in New England as well as to avoid potential acquisition of two banks.

Moreover the merger will result in geographical expansion and will increase the portfolio of both banks by merging their commercial and corporate clients. In the commercial banking industry, inter-state mergers have a history of cost savings up to 35% of non-interest expense incurred by the target bank which can bring synergies for the combined group. Therefore, the merger between SNC and BKB will bring economic benefit to both the entities.

Q2.) Evaluate whether the proposed merger with Bank of Boston is a good deal for Shawmut in December 1991: (i) What is Shawmut worth as a stand-alone? (ii) What is Shawmut worth if it is merged with Bank of Boston and the anticipated cost savings are realized?  How sensitive is your answer to variations in the cost saving assumptions?
Note:  To do the valuations, you should use a "cash flow to equity" approach.  In particular: (i)  Get the free cash flows to common equity from Exhibit 7. (ii) Determine an appropriate discount rate. (iii) Calculate a terminal value post-1996 assuming growth at a 3% inflation rate.
Based on evaluation of projected free cash flows of Shawmut National Corporation (SNC) by using the free cash flows to equity (FCFE) method; equity value of SNC’s operations on stand-alone basis is $625.46/- million and if SNC merges with BKB and estimated cost saving are realized than the equity value of the SNC will increase by $994.26/- million. The synergy effect of $994.26/- million explicitly shows that merger will increase the equity value of both SNC and BKB.

Sensitivity analysis of cost saving assumption reveals that around 128% decrease in present value of cost savings from non-interest expenses will be required to exploit the cost saving synergies. Therefore, the merger will be beneficial for SNC to gain more value against its equity.

Q3.) When valuing a bank, why does it make sense to use the "cash flow to equity" approach instead of the entity or firm approach that we have used in the previous cases?  Recall that in the firm approach, we value the cash flows to debt and equity and then subtract out existing debt to get a value for equity. What are the strengths and weaknesses of the two approaches?

Free cash flows to equity approach uses the free cash flows relevant to equity holders and deducts the cash flows resulting from the interest payments on loans, repayment of loan on maturity and new loans acquired during the period. Moreover, the free cash flows to equity are discounted using the cost of equity which makes it more relevant to the equity holders. While banks are using loans and debts to generate revenues hence; valuation based on free cash flows to equity will be more appropriate.

Strengths and Weaknesses of the Two Approaches

Free cash flows to equity provides detailed analysis of financings through debt capital but the forecast of debt repayments and new debt requirements will be difficult process.

Free cash flows to firm will change if the capital structure is changed, for example FCFF will show higher values by replacing the long term debt capital with equity capital hence it will save interest payments.
Free cash flows to firm discounts the free cash flows using weighted average cost capital, which requires information regarding debt/equity ratios and................................

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