Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

Table of contents
The Legal Forms of Acquisition
Taxes and Acquisitions

Chapter 26: Mergers and Acquisitions

Accounting For Acquisitions

Gains from Acquisitions
Some Financial Side Eects of Acquisitions
The Costs of an Acquisition
Defensive Tactics
Some Evidence on Acquisitions: Do M&As Pay?
Divestitures and Restructurings

Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

The Legal Forms of Acquisition

The Legal Forms of Acquisition

I. Merger versus Consolidation => both types of reorganization as mergersAcquisitions

a private offer from the
management of one firm to another.

Merger cong ty mua

One rm is acquired by another. Acquiring rm (acquirer) retains

name and acquired rm (acquired) cease to exist.


Advantage - simple to organize and cheaper than the

alternatives

Disadvantage - must be approved by shareholders of both

rms; gaining approval can be slow and costly

An acquisition of stock is the purchase by one rm of a

controlling stake (voting stakes) in another rm


Consolidation cong ty moi

This can be done as a public oer to buy the shares on the

market (a tender oer) of another rma general mailing is used in a tender
offer.
shareholder approval for the deal is not required, the managers
of the target rm are not necessarily consulted and the
acquisition can be unfriendly (hostile) they are not required to accept it and need
not tender their shares.

An acquisition of assets is the purchase of the assets of

another rm - it has the similar eect as an acquisition of
stock but the target rm does not necessarily cease to exist.

Entirely new rm is emerged from combination of existing rms.

cong ty bi mua van ton tai

A formal vote of the target

stockholders is
required in an acquisition of
assets.

A consolidationis the same as a merger except that an entirely new firm is created. In
a consolidation both the acquiring firm and the acquired firm terminate their previous legal
existence and become part of the new firm.
votes of the owners
of two-thirds of the shares are required for approval both the acquiring and the acquired firms. In addition, shareholders of the
acquired firm have appraisal rights. This means that they can demand that the acquiring firm purchase their shares at a fair value. Often the acquiring firm and
the dissenting shareholders of the acquired firm cannot agree on a fair value, which results
in expensive legal proceedings.
Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

The Legal Forms of Acquisition

The Legal Forms of Acquisition

Acquisitions

Takeovers
Takeover

Three most frequently observed types of activity are

1. Horizontal: both rms are in the same industry; create one
large rm that occupies more dominant market position
2. Vertical: rms are in dierent stages of the production process

A general (and imprecise) term referring to the transfer of control

of a rm from one group to another.
Possible forms of takeovers
 Acquisition


3. Conglomerate: rms are unrelated




takeovers encompass a broader set of activities than

acquisitions

Merger and Consolidation

Acquisition of stock
Acquisition of assets

Proxy Contest

Going Private

Proxy contests occur when a group of shareholders attempts to gain seats

on the board of directors. A proxyis written authorization for one
shareholder to vote the stock of another shareholder. In a proxy contest, an
insurgent group of shareholders solicits proxies from other shareholders.

In going-private transactions, a small group of investors purchases all the equity

shares of a public firm. The group usually includes members of incumbent management
and some outside investors. The shares of the firm are delisted from stock exchanges and
can no longer be purchased in the open market.
EX: Jack is a major shareholder of Lexington Homes stock. Currently, he is quite upset with the firm's
management and thus has decided to try and gain control of the firm by soliciting enough shareholder votes to
replace the current managers

Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

Taxes and Acquisitions

Accounting For Acquisitions

Taxes

Accounting for Acquisitions

Taxable acquisition


Firm purchased with cash

Capital gains taxes - shareholders of target may require a

higher price to cover the taxes The increase in value from writing up assets

Assets are revalued - aects deprecation expenses




Pooling of interests accounting no longer allowed

Purchase accounting


is considered a taxable gain.

MCQ

Tax-free acquisition


Business purpose; not solely to avoid taxes

Continuity of equity interest - target shareholders must be

able to maintain an equity interest in the combined rm

Generally, stock for stock acquisition

Assets of acquired rm must be reported at fair market value

Goodwill is created - dierence between purchase price and
estimated fair market value of net assets
Goodwill no longer has to be amortized - assets are essentially
marked-to-market annually and goodwill is adjusted and
treated as an expense if the market value of the assets has
decreased

How are these synergistic gains shared?

In general, the acquiring firm pays a premium for the acquired, or target, firm. For
example, if the stock of the target is selling for $50, the acquirer might need to pay $60
a share, implying a premium of $10 or 20 percent. The gain to the target in this
example is $10.
Suppose that the synergy from the merger is $30. The gain to the acquiring firm, or
bidder, would be $20 ($30 $10).
=> The bidder would actually lose if the synergy were less than the premium of $10.

Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

Gains from Acquisitions

Gains from Acquisitions

II. Synergy

Synergy

Synergy
The positive incremental net gain associated with the combination
of two rms through a merger or acquisition
Some mergers create synergies because the rm can either cut
costs or use the combined assets more productively
This is generally a good reason for a merger
1

Let rm A be the acquirer, rm B be the target, and rm AB be

the combined rm following an acquisition. Firm values are
denoted, in this order, by VA , VB , and VAB .
2
A successful merger requires that the value of the combined exceed
the sum of the parts
VAB > VA + VB
The synergy gain is

Examine whether the synergies create enough benet to justify the

cost

VAB = VAB (VA + VB ) > 0

incremental net gain

CFt = Rev - Costs - Taxes - Capital Requirements

Are there other motives for a merger besides synergy? Yes.

- synergy is the source of benefit to stockholders. However, the managers are likely to view a potential merger differently. Even if the synergy from
the merger is less than the premium paid to the target, the managers of the acquiring firm may still benefit. For example, the revenues of the combined firm
after the merger will almost certainly be greater than the revenues of the bidder before the merger. The managers may receive higher compensation once
they are managing a larger firm. Even beyond the increase in compensation, managers generally experience greater prestige and power when managing a
larger firm. Conversely, the managers of the target could lose their jobs after the acquisition. They might very well oppose the takeover even if their
stockholders would benefit from the premium.
Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

Gains from Acquisitions

Gains from Acquisitions

A combined firm may generate greater revenues than

III.Source of Synergy

1. Revenue Enhancement two separate firms. Increased revenues can come from
marketing gains, strategic benefits, and market power.
Marketing: mergers and acquisitions can increase
operating revenues. Improvements can be made in
the following areas:
 Advertising
1. Previously ineffective media programming and
 Distribution network advertising efforts.
2. A weak existing distribution network.
 Product mix
3. An unbalanced product mix.

Marketing gains

Synergy is obtained from four main sources

Improvements in at least one of

these four categories create synergy

1. increased revenue
2. decreased costs
3. reduced corporate taxes
4. lower cost of capital

firm get larger=> bank will reduce $

Strategic benets


Joined technology

Entry into new markets

Market power


Reduce/eliminate competition
=> If so, prices can be increased, generating monopoly profits.
However, mergers that reduce competition do not benefit society, and the U.S.
Department of Justice or the Federal Trade Commission may challenge them.

Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

Gains from Acquisitions

Gains from Acquisitions

2 Cost Reductions
.

3. Taxes and Financial Synergy

Economies of scale


Average production costs decrease as production increase

Most common in industries that have high xed costs

Best in horizontal mergers

Use of accumulated tax losses



Economies of vertical integration

High income rm combining with a rm with operating losses

or large unused tax deductions Table 29.1
Combined rm has enough income to use tax losses or
deductions
case 1

=> Economies from vertical integration probably

explain why most airline companies own airplanes.
 Use of unused debt capacity - Too little debt reduces firm value
 Coordinate operations more eectivelyThey also may explain why some airline
- A firm with little or no debt is an
companies have purchased hotels and car rental  Finance acquisition with debt
 Reduced search costs for suppliers or customers
companies.  Increase tax shield and reduce WACC inviting target => An acquirer could
raise the targets debt level after the
merger to create a bigger tax shield.
ski equipment store merging with a tennis equipment store
Complimentary resources A
will smooth sales over both the winter and summer seasons,
A or B leverage ratio below optimal => raise debt=> invest to buy another firm
thereby making better use of store capacity


Make better use of existing resources

=> benefit of leverage: tax and cost of capital

Technology transfer: An automobile manufacturer might well acquire an aircraft company if aerospace technology can improve automotive quality.
This technology transfer was the motivation behind the merger of General Motors and Hughes Aircraft.

Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

Gains from Acquisitions

Gains from Acquisitions

4. Reducing Capital Needs and Cost of Capital

Motives for M&A

=> Capital requirements: fixed capital and working capital.



A merger may reduce the required investment in working

capital and xed assets relative to the two separately operated
rms => economies of scale

Some assets may be sold if they become redundant in the

combined rm

Larger rms have better access to capital markets and greater

liquidity (economies of scale) diversification

Eliminating ineciencies



Operational ineciencies
Managerial ineciencies

Expansion

Managerial ambition

EPS growth

Combined rm may result in less-volatile cash ows, hence

lower default risk and lower cost of capital

Debt Capacity: case 1 & 2

Case 2: Increased Debt Capacity
To summarize, we first considered the case
Because the risk of the combined firm is less than that of either one separately,
where the target had too little leverage.
banks should be willing to lend more money to the combined firm than the total of what they would lend to the two firms separately. => The acquirer could infuse the target with
In other words, the risk reduction that the merger generates leads to greater debt capacity.
more debt, generating a greater tax shield.
Next, we considered the case where both target
EX:For example, imagine that each firm can borrow $100 on its own before the merger.
and acquirer began with optimal debt levels. A
Perhaps the combined firm after the merger will be able to borrow $250 => Debt capacity has increased by $50 ($250 $200).
merger leads to more debt even here. That is,
the risk reduction from the merger creates
=> If debt rises after the merger, taxes will fall. In other words, the increased debt capacity from a merger can reduce
greater debt capacity and thus a greater tax
taxes.
shield
Chapter 26: Mergers and Acquisitions
Some Financial Side Eects of Acquisitions

Chapter 26: Mergers and Acquisitions

Two Bad Reasons for Mergers

I. EPS Growth

Some Financial Side Eects of Acquisitions

Example - EPS Growth

Table 29.2

Mergers may create the appearance of growth in earnings per

share

If there are no synergies or other benets to the merger, then

the growth in EPS is just an artifact of a larger rm and is
not true growth

In this case, the P/E ratio should fall because the combined
market value should not change Firm As P/E should drop when it

There is no free lunch

takes on a new division with low growth.

- Smart market: Market value of combined stocks = A + B => P/E ratio of combined stocks
- Pooled market: P/E ration of stock A (acquirer) => Market value of combined stocks

Consider two rms, A and B who are planning to merger using an

issue of new rm A stock. Assume there are no economic or
nancial synergy gains from the deal.
Firm A
Firm B
Combined Firm AB
Market Value (MV) 4,000,000 2,000,000
6,000,000
Earnings
200,000
200,000
400,000
Number of shares
100,000
100,000
150,000
outstanding (N)
Price per share (P)
40
20
40 = 6,000,000/150,000
EPS(E)
2
2
2.667 = 400,000/150,000
P/E ratio (PE)
20
10
15 = 40/2.667
- a share of B is selling for 50 percent ( $20/$40) of the
price of a share of A

=> 0.5 x 100 shares B = 50 shares A

or = 6,000,000/400,000
= 15

Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

Some Financial Side Eects of Acquisitions

Some Financial Side Eects of Acquisitions

II. Diversication

Exmaple - EPS Growth

Whilst total earnings have doubled, the number of shares has only
increased by 50%, therefore EPS has increased!


This is called the Bootstrap eect

The gain is really an illusion, there are no economic or

nancial gains in the merger and the P/E ratio has actually
droped

- Stockhonderl: an individual benefits from portfolio

diversification, diversification from a merger may actually
hurt the stockholders.


Diversication, in and of itself, is not a good reason for a

merger

Shareholders can normally diversify their own portfolio

cheaper than a rm can diversify by acquisition

Shareholder wealth may actually decrease after the merger

because the reduction in risk, in eect, transfers wealth from
the shareholders to the bondholders

Shareholders are no better o. When the merger is costly,

shareholders are worse o.

- the bondholders are likely to gain from the merger

because their debt is now insured by two firms, not just
one
- Example TB: Loss to stockholders in firm A: $20 - $25 = $5
Loss to stockholders in fi rm B: $10 - $12.50 = - $2.50
Combined gain to bondholders in both fi rms: $45.00 - $37.50 = $7.50

Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

Some Financial Side Eects of Acquisitions

General Rules

Some Financial Side Eects of Acquisitions

The NPV of a Merger

Acquisition Gains and Costs

Gain > cost => mean synergy

Do not rely on book values alone - the market provides

information about the true worth of assets

Evaluating an acquisition is just like evaluating any other

investment

Estimate only incremental cash ows

Use an appropriate discount rate

It should only go ahead if the gain exceeds the cost, hence a

positive NPV project

Take into account transaction costs - these can add up

quickly and become a substantial cash outow

The gain is the dierence between the merged rm and the

sum of the values of the separate rms (the synergy)

Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

The Costs of an Acquisition

The Costs of an Acquisition

I. Cash Acquisition

Merger Premium


NPV = V + VB Cash Cost = V (Cash Cost VB )

The NPV of a cash acquisition is

NPV = VB Cash Cost to Firm A
where VB (= VB + V = VAB VA ) is the total value of rm
B (the target) accruing to rm A (the acquirer).

The post-merger value of the combined rm (after paying the

cash cost) is

We can rewrite the NPV of an acquisition as




VA + NPV = VA + (VB Cash Cost) = VAB Cash Cost.

where V is the gain (the synergy) of the acquisition and

(Cash Cost VB ) is the cost of the acquisition.
Caveat: tell the dierence between the Cash Cost and the
Cost of the acquisition.
The cost (premium) in a cash bid is the observed market
premium paid over the market value of rm B plus the
dierence between the market and intrinsic values of B
Cost = (Cash Cost MVB ) + (MVB VB )

Caveat: tell the dierence between the market value (MV ) of

a rm and its intrinsic value (V )

Chapter 26: Mergers and Acquisitions

Chapter 26: Mergers and Acquisitions

The Costs of an Acquisition

The Costs of an Acquisition

Example: Cash Acquisition



Data: two rms A and B with





VA = $200M, VB = $50M
NA = 4M, PA = $50
VAB = $275M, Cash = $65M

Cash Acquisition
Value of firm A after the acquisition = Value of combined firm - Cash paid
= 275 - 65 = 210 (gain - cost)
 However, rm As share price may drop when the deal is
= 210 - 200 = 10 (NPV)
announced

Gain = VAB (VA + VB ) = 275 (200 + 50) = $25M

Cost = Cash VB = 65 50 = $15M

NPV = 25 15 = $10M

Firm As post-merger share price becomes

exam

(275 65)
PA =
= $52.5
4

If this happens, the market is sending a clear message that

either the merger benets are doubtful or that A is paying way
too much for B

The market value of B may overstate its intrinsic value as a

separate entity (why and when?)

In this case the cost of the merge is increased by the

overstatement
cost = (cash cost -MV B) + (MV B - VB)

or P(a) + NPV/4 = 50 + 10/4 = 52.5

Chapter 26: Mergers and Acquisitions

The Costs of an Acquisition

II. Stock Acquisition




Value of the combined rm VAB = VA + VB + V

Cost of acquisition


depends on the number of new shares given to the target

shareholders (NN )
depends on the price of the combined rms stock post-merger
PAB
Cost = NN PAB VB

Chapter 26: Mergers and Acquisitions

The Costs of an Acquisition

Example: Stock Acquisition



Firm A has 4M shares outstanding (NA ) and it oers another

1.3M new shares (NN ) rather than $65M in cash.

A quick calculation of the cost gives

Cost = (NN PA ) VB = 1.3 50 50 = $15M

Hold on! We have to substitute in PAB ! P (AB) > P (A) & P(B)
PAB = 275/(4 + 1.3) = $51.89 > $50 => OVERPAID

The actual cost of the stock acquisition is

Cost = (NN PAB ) VB = 1.3 51.89 50 = $17.46M

Where do the additional $2.46M go?

VALUE THE COMBINED FIRM SHARES

=> The true cost to firm A is greater than $15

Chapter 26: Mergers and Acquisitions

The Costs of an Acquisition

III. Stock versus Cash Acquisition

Chapter 26: Mergers and Acquisitions

Defensive Tactics

Defensive Tactics
chien luoc phong thu

Considerations when choosing between cash and stock:



Corporate charter



=> the acquirer can gain control of only one-third of

the seats in the first year after acquisition. Another year must
pass before the acquirer
is able to control two-thirds of the seats. Therefore, the
acquirer may not be able to
change management as quickly as it would like

Establishes conditions that allow for a takeover

Super-majority voting requirement => this percentage is above 50

Share gains - target shareholders dont participate in stock

price appreciation with a cash acquisition

Targeted repurchase (a.k.a. greenmail)though the number can be much

Taxes - cash acquisitions are generally taxable

Standstill agreements

Control rights - cash acquisition do not dilute control rights

Poison pills (share rights plans)

Leverage buyouts => issue debt to pay out a dividend

- Target repurchase: to forestall a takeover attempt. In a targeted repurchase,

a firm buys back its own stock from a potential bidder, usually at a substantial premium,
with the proviso that the seller promises not to acquire the company for a specified period.
Critics of such payments label them greenmail.

- Leverage buyout: Going-private transactions in which a large percentage of

the money used to buy the outstanding stock is borrowed
or A small group of investors banded together and borrowed the funds necessary
to acquire all of the shares of stock of a publicly-traded firm

percent. 2/3 majorities are common,

higher.

- Standstill: As part of the agreement, the acquirer often promises to offer the target a right
of first refusal in the event that the acquirer sells its shares. This promise prevents the block
of shares from falling into the hands of another would-be acquirer.

- Poison pills: At one point in 2005, PSs poison pill provision stated that once a bidder
acquired 20 percent or more of PeopleSofts shares, all stockholders except the acquirer
could buy new shares from the corporation at half price.

Chapter 26: Mergers and Acquisitions

Defensive Tactics

Other Devices and Jargon of Corporate Takeovers



Golden parachute

Poison put

Crown jewel

White knight

Lockup

Shark repellent

Bear hug

Fair price provision

Dual class capitalization

Counter-tender oer

Chapter 26: Mergers and Acquisitions

Some Evidence on Acquisitions: Do M&As Pay?

Evidence on Acquisitions II
Firm A

Shareholders of bidding rms, on average, do not earn or lose a

large amount


Anticipated gains from mergers may not be achieved

Bidding rms are generally larger, so it takes a larger dollar

gain to generate the same percentage gain

Management may not be acting in the best interest of

shareholders

Takeover market may be competitive

Announcement may not contain new information about the

bidding rm

Chapter 26: Mergers and Acquisitions

Some Evidence on Acquisitions: Do M&As Pay?

Origin of the Benets

Chapter 26: Mergers and Acquisitions

Some Evidence on Acquisitions: Do M&As Pay?

Evidence on Acquisitions I

Firm B

Target shareholders tend to earn excess returns in a merger



Target shareholders gain more in a tender oer than in a

straight merger

Target rm managers have a tendency to oppose mergers,

thus driving up the tender price

Chapter 26: Mergers and Acquisitions

Some Evidence on Acquisitions: Do M&As Pay?

Origin of the Benets

gain B > loss A



The gains received by the target rm are usually greater than

the losses to the acquirer
Where do they come from?


Myopia: rms that engage in long-term strategies are

frequently under-valued and become targets
Undervalued target theory: the market reviews its opinion of
the target when the acquisition is launched and may realize
that the target was undervalued
The tax eect theory: there can be tax benets but these
depend on the country

Chapter 26: Mergers and Acquisitions

Divestitures and Restructurings

Divestitures and Restructurings

Divestiture
rm sells a piece of itself to another rm

The Hubris Hypothesis (Roll (1986))



Takeovers gains do not exist or, in the few cases where they
do, are overestimated

The value of the oer premium signicantly overstates the

increase in economic value (the synergy), resulted from the
combination of the rms and this is the only real source of
gains in the acquisition process

Equity carve-out
rm creates a new rm out of a subsidiary and then sells a
minority interest to the public through an IPO

Spin-o
rm creates a new rm out of a subsidiary and distributes the
shares of the new rm to the parent companys shareholders

Split-up
rm is split into two or more rms, and shares of all rms are
distributed to the original rms shareholders

Chapter 26: Mergers and Acquisitions

Divestitures and Restructurings

Quick Quiz

What are the dierent methods for achieving a takeover?

How do we account for acquisitions?

What are some of the reasons cited for mergers? Which may
be in shareholders best interest, and which generally are not?

What are some of the defensive tactics that rms use to

thwart takeover?

How can a rm restructure itself? How do these methods

dier in terms of ownership?