Mergers and Acquisitions – Firm A should make the acquisition

Bidder firm (acquiring firm)– the company making an offer to buy the
stock or assets of another firm
Target firm (acquired firm)– the firm that is being sought
• There are three basic legal procedures that one firm can use to
acquire another firm:
1. Merger – The complete absorption of one company
by another (assets and liabilities), Acquiring firm retains name and
acquired firm ceases to exist, Consolidation– Entirely new firm is
created from combination of existing firms. • Advantage – legally
simple and relatively cheap. • Disadvantage – must be approved by a
majority vote of the shareholders of both firms, usually requiring the
cooperation of both sets of management
2. Acquisition of Stock – A firm can be acquired by
another firm or individual(s), purchasing voting shares of the firm’s
stock, – Tender offer – public offer to buy shares of a target firm, – No
stockholder vote required, – Can deal directly with stockholders, even
if management is unfriendly, – May be delayed if some target
shareholders hold out for more, money – complete absorption requires
a merger
3. •Acquisition of Assets – One firm buys most or all
of another’s assets., – A formal vote of the target stockholders is
required, – Transferring titles can make the process costly. The selling
firm may remain in business.
Classifications
• Horizontal acquisition– both firms are in the same industry, – both
firms are in direct competition and share the same product lines and
markets.
• Vertical acquisition – firms are in different stages of the production
process, – customer and company or a supplier and company, – Think
of a cone supplier merging with an ice cream maker,
• Conglomerate acquisition – firms are unrelated
Synergy
Suppose firm A is contemplating acquiring firm B. The synergy
from the acquisition is
Synergy = VAB – (VA + VB)
Synergy occurs if the value of the combined firm after the merger is
greater than the sum of the value of the acquiring firm and the value of
the acquired firm before the merger.
The synergy of an acquisition can be determined from the standard
discounted cash flow model:
Revenue Enhancement – Marketing gains
 changes in advertising efforts, changes in the
distribution network, changes in the product mix
 Strategic benefits– acquisitions that allow a firm to
enter a new industry that may become a platform for further expansion
 Market power – reduction in competition or increase
in market share
Cost Reduction
– Economy of scale >the average cost of production falls as the level
of production increases.
– Economies of vertical integration > coordinating closely related
activities
– Technology transfer
– Complementary resources > improving usage of existing resources.
– Replacement of ineffective managers > If management is not doing
its job well, or others may
be able to do the job beder, acquisitions are one way to replace
management
Tax Gains
– Net operating losses – a firm with losses and not paying taxes may be
adractive to a firm with
significant tax liabilities
– Debt Capacity - adding debt can provide important tax savings •
Unused debt capacity - target has too lidle debt, and the acquirer can
infuse the target with the missing debt., • Increased debt capacity - A
merger leads to risk reduction, generating greater debt capacity.
Reduced Capital Requirements – fixed assets and working capital
Earnings Growth
– If there are no synergies or other benefits to the merger, then the
growth in EPS is just an artifact of a larger firm and is not true growth
(i.e., an accounting illusion).
– An acquisition may give the appearance of growth in EPS without
actually changing cash flows. This happens when the bidder’s stock
price is higher than the target’s, so that fewer shares are outstanding
aaer the acquisition than before.
Diversification
– A firm’s adempt at diversification does not create value because
stockholders could buy the stock of both firms, probably more cheaply.
– The reduction in risk from a merger may actually help bondholders
and hurt stockholders.
A Cost to Stockholders from Reduction in Risk
 The Base Case – If two all-equity firms merge, there
is no transfer of synergies to bondholders. Thus, the stockholders of
both firms are indifferent to the merger.
 Both Firms Have Debt – Stockholders in Firm A
receive stock in Firm AB worth $20. – Stockholders in Firm B receive
stock in Firm AB worth $10. – Gains and losses from the merger are: •
Loss to stockholders in Firm A: $20 − $25 = −$5 • Loss to stockholders
in Firm B: $10 − $12.50 = −$2.50 • Combined gain to bondholders in
both firms: $45.00 − $3ti.50 = $ti.50. Coinsurance effect - When one of
the divisions of the combined firm fails, creditors can be paid from the
profits of the other division. It makes the debt less risky and more
valuable than before. – Stockholders are hurt by the amount that
bondholders gain.
How Can Shareholders Reduce their Losses from the Coinsurance
Effect? Retire debt pre-merger and/or increase postmerger debt usage
The NPV of a Merger
Typically, a firm would use NPV analysis when making acquisitions.
The analysis is straighcorward with a cash offer, but it gets complicated
when the consideration is stock.
2. Synergy = VAB – (VA + VB)
= $ti00 – ($500+$100) = $100
– Premium = amount paid above the stand-alone value
= Cash paid – VB = $150-100 = $50
– NPV of a merger = Synergy – Premium
= $100 - $50 = $50
– NPV of a merger = Synergy – (Cash paid – VB ) = VB + Synergy –
Cash paid
Stock Acquisition
Firm A could purchase Firm B with common stock. – Depends on the
number of shares given to the target stockholders, – Depends on the
price of the combined firm’s stock after themerger
• Case 1:
– Exchange ratio = 0.75:1, Firm A exchanges 7.5 of its shares for
the entire 10 shares of Firm B.
– Aaer merger, Firm A share outstanding = 25 + 7.5 = 32.5
– Firm B shareholders = 7.5/32.5 = 23 percent of the combined
firm
– Total value of Firm B shareholders after the merger
= $700 × 23%= $161 > $150
– Price per share = 700/32.5 = $21.54
Case 2:
– What should the exchange ratio be so that Firm B
stockholders receive only $150 of Firm A’s stock?
– α = the proportion of the shares in the combined firm that
Firm B’s stockholders own.
– Aaer merger, value of Firm B shareholders = α × $700 = $150, thus α
= 21.43%
– New shares issued = 6.819 shares
– The exchange ratio = 0.6819 : 1
– Total share outstandings = 25+6.819 = 31.819
– Price per share = $700/31.819 = $22
Considerations when choosing between cash and stock: – There is no
easy formula. – The most important is the price of the bidder’s stock. –
Both theory and empirical evidence suggest that
firms are more likely to acquire with stock when their own stocks are
overvalued. – Empirical evidence shows that the acquirer’s stock price
generally falls upon the announcement of a stock-for-stock deal.
Do Mergers Add Value?
Event studies - es7mate abnormal stock returns around the merger
announcement date. – Abnormal return - the difference between an
actual stock return and the return on a market index.
Both acquired and acquiring firms – The average abnormal percentage
return across all mergers from 1980 to 2001 is 1.35 percent. –
However, the aggregate dollar change around the day of merger
announcement is −$79 billion. – Although most mergers have created
value, mergers involving the very largest firms have lost value. –
Overall, the results are ambiguous.
Acquiring firms (bidding firms) – Abnormal percentage returns for
Acquiring firms have been positive for the entire sample period and for
each of the individual subperiods. – The aggregate dollar change
around the day of merger announcement is −$220 billion, suggesting
that large mergers did worse than small ones. – Again, the evidence is
ambiguous.
Acquired companies (target firms) > acquisitions benefit stockholder.
The premium is the difference between the acquisition price per share
and the target’s preacquisition share price, divided by the target’s
preacquisition share price.
Managers versus Stockholders
Managers of bidding firms – Agency theory for mergers - because firm
size increases with acquisitions, managers are disposed to look
favorably on acquisitions, even ones with a
negative NPV.
– The merger failures of large acquirers may be due to the small
percentage ownership of the managers.
• Managers of target firms – Fear of displacement may lead managers
to reject bids, thereby giving up premiums for stockholders.

Cash Acquisition
1. Firm B is offered $150 in cash.
– Value of Firm A aaer the acquisition (VA*)
= Value of combined firm – Cash paid
= $ti00 - $150 = $550
– Price per share = $550/25 = $22
– NPV of a merger= VA* - VA = $550 - $500 = $50