Advanced Accounting I Types of Business Combinations

(DAC 3033)
Friendly Combinations

Chapter 1: Introduction to
Boards of directors of both
Business Combinations
companies negotiate
terms of proposed
combination.

Obj 1 1-1

Types of Business Combinations Defense Tactics

Poison pill: stock rights of shareholders to

Unfriendly (Hostile)
Combinations purchase additional shares at a bargain price
Board of directors of in the event of a potential takeover.
target company resists the Greenmail:
combination.
purchase of shares
The acquiring company
deals directly with held by acquiring
individual shareholders company at a
through a tender offer. premium price.
Obj 1 1-2 Obj 4 1-3

Defense Tactics Business Combinations: Why?

White knight or white squire: encourage a Operating synergies

friendly firm to acquire the target company.
Competitiveness in the international
marketplace
?
Selling the crown jewels: sale of valuable assets
to make the firm less attractive.
? ?
Financial synergy

Leveraged buyout: managers and investors Diversification

purchase controlling interests and take the firm Divestitures

private.
? ?
Obj 4 1-4 Obj 2 1-5
 Business Combinations: Why Not? Business Combinations:
Historical Perspective
Insufficient management control over the 1880-1904: horizontal integration
resulting conglomerate, resulting in future
divestitures.
? ? 1905-1930: vertical integration

Business combinations may enable suboptimal 1945-present: merger mania

allocation of capital.
Accounting method may encourage firms to
?  1970s:

 1980s -
conglomerate mergers
present:
pay too much.
? ?
strategic acquisitions

Obj 2 1-6 Obj 1 1-7

Types of Combinations Stock Acquisition VS Asset Acquisition

What is acquired: What is given up: How it is accounted for:

Stock Acquisition Asset Acquisition
 may obtain control by  must acquire 100% of
Cash acquiring 50% of voting target firm, hence higher
common stock cost
Net assets of Purchase Method
S Company
Debt
 can avoid formal negotiation  need to negotiate with
with target management target management

Stock
Common stock  maintain separate legal  no separate legal entity
of S Company
entity
Combination of
above
Obj 5 1-8 Obj 5 1-9

Types of Combinations Determining Price

Statutory Merger Price

A Company B Company A Company  effect of acquisition on future earnings
+
 value of the firm’s identifiable net assets
Statutory Consolidation
 estimated value of implied goodwill
A Company + B Company C Company
Stock exchange ratio
 number of shares of acquiring company to
Stock Acquisition
Consolidated Financial
be exchanged for each share of the
Financial Statements Financial Statements
of A Company + of B Company
Statements of A acquired company
and B Companies

Obj 5 1 - 10 Obj 6 1 - 11
 Determining Method of Payment Estimate Implied Goodwill

Cash or stock? By discounting expected future excess earnings

 identify normal rate of return for similar firms
 apply rate of return to net assets of target firm to
Factors affecting method of payment: estimate normal earnings
 liquidity position of acquiring firm  estimate expected future earnings of target
 willingness of sellers to accept  excess earnings = expected normal
alternative forms of payment -
earnings earnings
 tax and accounting issues  goodwill = discounted value of excess earnings

Obj 6 1 - 12 Obj 7 1 - 13

Implied Goodwill Example IMPLIED GOODWILL CALCULATION

Parent Co. is buying Sub Co.
Parent estimates Sub will earn SUB'S ESTIMATED ANNUAL EARNINGS $824,000
$824,000 next year
LESS: NORMAL FOR INDUSTRY 532,000
Companies similar to Sub Co. earned
292,000
$532,000 last year
Parent requires a 15% rate of return on PRESENT VALUE FACTOR 4.16042
this investment (7 YEARS, 15%, ORDINARY ANNUITY)

Parent assumes excess earnings will

continue for seven years IMPLIED GOODWILL $1,214,843
Obj 7 1 - 14 Obj 7 1 - 15

THE END