Вы находитесь на странице: 1из 123

Theories in Merger and Acquisition

Prepared by: Vishal Goel

4/4/2013

Mergers and Acquisitions


Definition of Merger Combining of two business entities under common ownership (Arnold 2005) Or Two firms coalesce and share resources in order to realise a common goal But One party almost always dominates so
4/4/2013 2

Mergers and Acquisitions


Acquisition One firm buys the assets or shares of another

Takeover implies the acquiring firm is larger than the target Reverse takeover if the target is larger than the acquirer

4/4/2013

Q1) What are the various ways a Corporate can achieve growth?
There are essentially two ways a Corporate can achieve growth. They are: Organic Route: In such a strategy, the Corporate undertakes projects and builds capacities by itself. Such a strategy is time consuming as the projects will have high gestation periods. Inorganic Route: M & A fall under this strategy. In such a case the Corporate takes over another existing firm

4/4/2013

The key benefit in this case is the reduction in gestation period. In these cases if the Corporates would have gone by the organic route, it would have been a couple of months, even years to add capacity. The same objective can be achieved in a significantly shorter time by a properly executed inorganic route. There are other significant benefits also.
4/4/2013 5

Q2) What are the other significant benefits of M&A?



The other significant benefits of M & A are:


A. Economics Of Scale And Economics Of Scope: - Reducing Fixed Cost/Unit. Economies of scale:In this case, the company increases its production capacity to such an extent that the fixed cost/unit decreases. Example: Fixed Costs No. of units Produced Fixed cost/unit

= = =

10 Lacs 10 Lacs 10 Lacs 20 Lacs Re. 1/- Re. 0.50/-

In such a case, by reducing the fixed cost/unit, the co. will be able to price its products better. This is the advantage of global capacities. Note: China has been using this technique and practicing dumping.
4/4/2013 6

Economics of scope:
Is aiming to reduce marketing expenses. By producing multiple products jointly at the cost lower than when production was spread across multiple firms. combining marketing or distribution for different types of related products, maybe horizontal or concentric In such a case, we find that the co. is looking at reducing its marketing expenses.

For e.g.: if a pharma co. XYZ has 100 salesman and other ABC has 50, then by taking over ABC and removing the 50 salesmen, the two units after merging can bring down its overall marketing costs. Both Economies of Scope and Economies of Scale will result in synergy (Synchronized energy). This essentially indicates that the whole unit formed after M &A is greater than sum of the merging units. In short 2 plus 2 equals 5.
4/4/2013 7

B. Acquisition of Intangibles: Often M & As are for acquisition of Intangibles like brands, patents, goodwill etc. In such cases the intangible assets are acquired at a heavy premium. c. Diversification. In this case the firms involved can offer better variety of products. Often firms resort to M & A as they can get access to new markets a prime example is that of Tata Steel with Corus. d. Technology / Skilled man power. Often Corporates go in for M & A to get access to new technology. All the M & As happening in the technology space are prime examples of the same. Also they may go in for M & A to get access to skilled management and manpower as seen in financial services investment banking firms. These are all examples of value creation. Apart from that, there could be the added advantage of value capture.
4/4/2013 8

Q 3) What is value capture?


Ans. Value capture essentially refers to the tax benefits that a Corporate will get when they go for M&A. Often loss making firms are acquired by Corporates for getting tax benefits. In such a case, the taxable profit of the firm comes down. For e.g. Co.XYZ with 100 cr profit and with a taxation rate of 20% will have to pay taxes of 20 crores. However, if it acquires a company ABC with losses of 30crores, its taxable profit will come down to 100- 30 =70 crores. The taxes in this case would be 14 crores. Thus, the co. is saving 20 14 = 6 crores. This is known as Value Capture. In this case the value is captured from the Govt. as less tax is paid. The Govt. is in favor of the same as M & A in case of sick Corporates generate employment. In fact the Govt. allows carry forward of losses in case the losses are so huge that they cannot be absorbed by the healthy units current years profits.

4/4/2013

Q4) What are the various ways in which M & A can be classified?
Ans. M & A can be further classified as: Inbound Deals: Foreign companies acquiring Indian corporates are examples of the same for e.g. Daichi of Japan taking over Ranbaxy. Outbound Deals: Indian Corporates acquiring foreign Corporates or brands are examples of the same. Hindalco of the Aditya Birla Group acquiring Novellis is an example of the same. Domestic Deals: These refer to the deals between Indian Companies. For e.g. the merger of Global Trust Bank with Oriental Bank of Commerce. It is significant to note that the outbound deals are increasing significantly showing increasing risk appetite of Indian Corporates.

Also though used interchangeably, there are significant differences between the terms Mergers and Acquisitions.

4/4/2013

10

Why Do Firms Merge?


Motives which Add to Shareholders Value:
a) b) c) d) e) f) g) h) Economies of scale Increased Revenue Increased Market Share Synergy Taxes Geographical or other Diversification Resource Transfer Vertical Integration Increased Market Share to increased Market Power

4/4/2013

11

Economies of scale
Combining company can reduce duplicate departments or operations Lowering the costs of the company Leading to profit average costs decline over a broad range of output

4/4/2013

12

Increased Revenue Increased Market Share


Assumption is that the company will be absorbing a major competitor Thus increase its power ( by capturing increased market share) to set prices

4/4/2013

13

Synergy
Underlying Principle for M&A Transactions 2+24 Additional Value of Synergy Synergy is ability of merged company to generate higher shareholders wealth than the standalone entities

4/4/2013

14

Taxes
A profitable company can buy a loss maker to use the targets tax write off. In U.S rules are placed in such an order that Limiting the tax motive of an acquiring company.

4/4/2013

15

Geographical or other Diversification


To smoothen the earnings of a company Giving conservative investors more confidence I investing in the company. Ex: Tata Motors acquired Daewoo Commercial Vehicle Company ( Republic of Korea) in 2003 Infosys Technologies Ltd. Acquired Expert Information Services Ltd. (Australia)

4/4/2013

16

Resource Transfer
Resources are unevenly distributed across firms Interaction of target and acquiring firm resources can create value through Overcoming information asymmetry Or by combining scarce resources

Ex: WIPRO acquired Nerve ireInc. (U.S) Reliance Info Com acquired Flagcom ( U.K)

4/4/2013

17

Vertical Integration
Vertical Integration : Internalization of crucial forward or backward activities Vertical Forward Integration Buying a customer Indian Rayons acquisition of Madura Garments along with brand rights Vertical Backward Integration Buying a supplier IBMs acquisition of Daksh

4/4/2013

18

Increased Market Share to increased Market Power


In oligopoly market increased market share allows companies to raise their market power

4/4/2013

19

Motives Which do not add to Shareholder Value


Diversification: This may hedge a company against downturn in an individual industry It fails to deliver value Since it is possible for individual to achieve the same hedge by diversifying their portfolio at a much lower cost than Those associated with a merger.

4/4/2013

20

Managers Hubris:
Managers overconfidence about expected synergies from M&A results in overpayment for the target company.

Managerial hubris is the unrealistic belief held by managers in bidding firms that they can manage the assets of a target firm more efficiently than the target firm's current management. Managerial hubris is one reason why a manager may choose to invest in a merger that on average generates no profits.

4/4/2013

21

Hypothesis about Mergers


There are a big number of hypothesis as to why mergers occur, these can be grouped into two broad categories: 1) Neoclassical theories that assume that managers maximize profits or shareholder wealth and thus that mergers increase either market power or efficiency 2) Non-neoclassical or behavioral theories that posit some other motivation for mergers and/or other consequences.
4/4/2013 22

1) Neoclassical Theories
a) Market Power Increases b) Efficiency Increases

2) Non-neoclassical or Behavioral
a) b) c) d) e) f) g) h)
4/4/2013

Speculative Motives The Adaptive Firm Hypothesis The Market for Corporate Control The Economic Disturbance Hypothesis Financial Efficiencies The Capital Redeployment Hypothesis The Life-Cycle-Growth-Maximization Hypothesis The Winners Curse- Hubris Hypothesis
23

(1a) Market Power Increases


Horizontal Mergers fewer firms in an industry have greater incentives to cooperate and raise the price A Horizontal mergers involves two firms operating and competing in the same kind of business activity Motives:

i.
ii. iii.

Elimination or reduction in competition


Putting an end to price-cutting Economies of scale in production

iv.

R&D, marketing and management

Herfindahl index is used


4/4/2013 24

Herfindahl index
The Herfindahl index, also known as Herfindahl-Hirschman Index or HHI, is a measure of the size of firms in relation to the industry and an indicator of the amount of competition among them. It is an economic concept widely applied in competition law, antitrust and also technology management The theory behind the use of the H-index is that if one or more firms have relatively high market shares, there is of even greater concern than the share of the largest four firms
4/4/2013 25

E.g.1: In one market four firms each hold 15% market share and the remaining 40% is held by 40 firms,

each with 1% market share. Its HHI would be:

H = 4(15) + 40(1) = 940

4/4/2013

26

E.g.2: In another market 1 firm has 57% market share and the remaining 43% is held by 43 firms, each

with 1% market share. What would be the Hindex?

4/4/2013

27

For e.g.: Two cases in which the six largest firms produce

90 % of the output:
Case 1: All six firms produce 15% each, and Case 2: One firm produces 80 % while the five others produce 2 % each. Assuming that the remaining 10% of output is

divided among 10 equally sized producers.

4/4/2013

28

A HHI index below 0.01 (or 100) indicates a highly

competitive index.
A HHI index below 0.1 (or 1,000) indicates an unconcentrated index. A HHI index between 0.1 to 0.18 (or 1,000 to 1,800) indicates moderate concentration.

A HHI index above 0.18 (above 1,800) indicates


high concentration
4/4/2013 29

Since a horizontal merger increases industry concentration, it increases H, it must also increase the industry price-cost margin and profits.

4/4/2013

30

Vertical mergers
Vertical mergers occur between firms in different stages of production operations Upstream & Downstream Mergers. by increasing the barriers

to entry at one or more links in the vertical production chain


Motives : i. ii. iii. Lower buying cost of materials Lower distribution costs Assured supplies and market

iv.

Increasing or creating barriers to


entry for potential competitors

4/4/2013

31

Conglomerate mergers
Conglomerate mergers involves firms engaged in unrelated types of business activity.

An increase in concentration leads to a greater increase in profits in

a market in which the sellers also face one another in other markets
than when such multimarket contact is not present. This motive may also be the cause of purposeful diversification mergers.
Product extension mergers Market extension mergers Pure Conglomerate mergers

Motive:
Diversification of risk.

4/4/2013

32

(1b) Efficiency Increases


Horizontal Mergers
AC
A B

C D

E
Output
4/4/2013 33

Vertical mergers
Can increase the efficiency of the merging firms by eliminating steps in the production process, which reduces the transaction costs from bargaining due to asset specificity Asset Specificity refers to the relative lack of transferability of assets intended for use in a given transaction to other uses. Highly specific assets represent sunk costs that have relatively little value beyond their use in the context of a specific transaction. Williamson has suggested six main types of asset specificity: Site, physical asset, human asset, brand names, dedicated assets, temporal specificity

High asset specificity requires strong contracts or internalization to combat the threat of opportunism. Small subcontractors locating and investing next to only customer who could potentially turn to alternative suppliers (site- and physical asset specificity).
4/4/2013 34

General Motors and Fisher Body 1919-1926


After a 10 year contractual agreement was signed in 1919, GM's demand for closed-body cars increased to extent that it became unhappy with the contractual price provisions and "urged Fisher to locate its body plants adjacent to GM assembly plants, thereby to realize transportation and inventory economies." [Williamson, AJS, p.561] Finally, Fisher Body was merged into GM in 1926 after Fisher had resisted GM's locational demands. As Coase recalls: "I was told [by GM officials] that the main reason for the acquisition was to make sure that the body plants were located next to General Motors assembly plants." [Coase, "The Nature of the Firm: Origin", in: Williamson & Winter, eds., The Nature of the Firm. 1993, p.43.]

4/4/2013

35

Conglomerate Mergers
Economies of scope (ESC) arise when the production of two different products by the same firm leads to lower production costs for one or both products. Example: warehousing and delivery of products

4/4/2013

36

In such an industry, one would expect the merging firms to be smaller than non-merging firms, because the expected cost reductions are greter for pairs of small firms.
Empirical Evidence:
In Belgium, Germany, USA, and UK merging firms were significantly larger than non-merging firms In France, the Netherlands, and Sweden merging pairs were in significantly different in size from randomly selected nonmerging companies.

4/4/2013

37

Non-neoclassical or Behavioral

4/4/2013

38

(2a) Speculative Motives


Studies of early merger waves often mention promoters profits as a cause for mergers. During these waves men like J.P. Morgan often approached corporate managers and suggested a possible merger. They earned large fees for their advice and for other services they rendered to facilitate and finance the deals. Underwriters of the securities floated in the great merger that created the United States Steel Corp. In 1901, earned fees of $575.5 million over $1 billion in todays dollars (The Economist, April 27, 1991, p. 11). Michael Milken
4/4/2013 39

Fee Revenue from underwriting and M&A transactions in 1998 (Saunders and Srinivasan, 2001 )
Investment Bank Morgan Stanley Goldman Sachs Merrill Lynch Credit Suisse First Boston DLJ Citibank Lehman J.P. Morgan Bankers Trust NationsBank Montgomery Average Fee Revenue from Underwriting (equity & debt) (1) 1253.8 1087.8 1496.9 386 491.8 913.2 516.3 358.9 252.2 132.7 688.9 Fee Revenue from Merger Advice (2) 302.9 531.2 321.3 287.4 200 189.1 199.2 70.9 56.9 26.2 218.5 (2) / (1) 19.50% 32.80% 17.70% 42.70% 28.90% 17.20% 27.80% 16.50% 18.40% 16.50% 23.80%

Total
4/4/2013

6889.6

2185.1

31.72%
40

(2b) The Adaptive (Failing Firm) Hypothesis


Donald Dewey (1961):
mergers as a civilized alternative to bankruptcy

John McGowan (1965):


An adaptive theory to account for why small firms are typically the targets in mergers and why the much more competitive US and UK economies had more mergers than the less competitive ones.

Two implications:
Mergers should follow a counter-cyclical pattern. Why dont we see merger waves during recessions? Profit rates of acquirers should be higher than targets

Empirical Evidence
Most studies of mergers in the USA have found that acquired firms have the same average profit rates as similar non-acquired companies During the conglomerate merger wave acquiring companies had below average profit rates and also profit rates lower than the firms they acquired.

4/4/2013

41

(2c) The Market for Corporate Control


Buyers in the market for corporate control would step in whenever valuation ration Vt falls short of its maximum value, and thus that this process ensures that corporate assets are managed by the most competent managers and those intend shareholder wealth maximization. Manne (1965): Mt: market value of the firm in year t Kt: the value of the assets of the firm in year t If Mt > Kt: the assets bundled together as a firm are worth more than their sum as measured by Kt. Marris (1963, 1964) called Mt / Kt the valuation ratio, Vt

4/4/2013

42

Tobin Q
The q-ratio Tobin (1969) measured Kt as the replacement cost of the firms asset and called qt = Mt / Kt.
Ratio of the market value of the firm's securities to the replacement costs of its assets
High q-ratio reflects superior management Depressed stock prices or high replacement costs of assets cause low q-ratios

4/4/2013

43

(2d) The Economic Disturbance Hypothesis


Gort (1969)
a group of non-holders suddenly raises its expectations about firm Bs future profits. If these non-holders are managers of another firm, the transaction takes the form of a merger. Mergers under this hypothesis are more likely to happen in periods in which stock market experiences rapid changes in value. Consistent with the wave pattern But also consistent with merger waves during sudden drops in stock market values (even more intense merger activity!)
4/4/2013 44

(2e) Financial Efficiencies


Savings on Borrowing Costs

Riskpooling

4/4/2013

45

(2f) The Capital Redeployment Hypothesis


Weston (1970)
Similar to financial efficiencies argument, but goes beyond it by positing ongoing potential gains from a central management teams ability to monitor the investment opportunities of each division and shift capital across them.

4/4/2013

46

(2g) The Life-Cycle Growth Maximization Hypothesis


Mueller (1969)
Mergers are the quickest way to grow and diversify and thus an attractive way for managers with limited time horizons to achieve growth. Predictions
diversification mergers by mature firms

4/4/2013

47

(2h) The Winners Curse Hubris hypothesis


There are a number of bidders The bidder with the highest valuation acquires the target With rational expectations, the expected true value of the target should be at the mean of the distribution The winner will bid too much! Why bid then? Roll (1986): Because managers of acquiring firms suffer from hubris, excessive pride and arrogance.
4/4/2013 48

Winner's Curse and Hubris


Winner's Curse: The winning bid in a bidding contest for an object of uncertain value will typically pay in excess of its true value One cause of the winner's curse phenomenon in M&As is hubris, defined as excessive optimism

4/4/2013

49

Theories Of Merger
Variety of reasons for M&A and the diversify of their consequences have given rise to a range of hypotheses. These hypotheses can be of 3 types: 1. Internalisation theory 2. Technological competence theory 3. Transaction cost theory

4/4/2013

50

Internalisation theory
It focuses on to acquire others because they want to produce intangible assets that generally give them a competitive advantage. Corporation must have intangible assets, and corporation make them profitable. It may include knowledge of a particular market, know how in a particular technology or an enviable reputation for product quality. These assets usually have 2 characteristics:
They must have the attributes of a public good ( their running costs within the corporation must be zero.) They must have high transaction costs so that most profitable way of acquiring them is through M&A rather than purchase or rental
4/4/2013 51

Technological competence theory


It is an extension of internalisation theory, developed by John Cantwell. It is based on internalisation of intangible technological assets. It assumes that technology consists of 2 factors:
One that can be codified ( written information about technology, plans etc. One that cannot be codified ( certain abilities needed to operate it , particular knowledge )

Corporations that engage in M&A are attempting to internalise technological advantages by acquiring the corporations that possess them.

4/4/2013

52

2nd attributes technological competence. Intangible assets. This theory has certain consequences: 1. When target corporation with high technology, potential purchasers will be more inclined to install R&D capacity, thus enhancing local innovation. 2. When local corporation have low technology , M&A may increase the Technology content. 3. When corporation engage in research but are not on the cutting edge of technology M&A may results in the complete absorption of the targeted industry.

4/4/2013

53

Transaction cost theory


It applies to vertical merger and acquisitions aimed at reducing uncertainty

or the cost of procuring particular factor of production

4/4/2013

54

Other Theories
1. 2. 3. 4. 5. 6. 7. Efficiency theory Monopoly theory Valuation theory Empire-building theory Process theory Raider theory Disturbance theory
55

4/4/2013

8. Information and signaling 9. Agency problems and managerialism 10. Free cash flow hypothesis 11. Market power 12. Taxes 13. Redistribution
4/4/2013 56

Efficiency Theories
1. Differential managerial efficiency 2. Insufficient management 3. Operating synergy

4. Pure diversification
5. Strategic realignment to changing environments 6. undervaluation
4/4/2013 57

1(1)Differential managerial efficiency


If the management of firm A is more efficient than the

management of firm B and if after firm A acquires firm b, the efficiency of firm b is brought up to the level of efficiency of firm A, efficiency is increased by merger.
Differential efficiency would be most likely to be a factor in mergers between firms in related industries

where the need for improvement could be more easily identified.


4/4/2013 58

1(2)Insufficient management
May simply represent management that is incompetent in an absolute sense. Almost anyone could do better.

The theory suggests that target management is so


incapable that virtually any management could do better, and thus could be an explanation for mergers

between firms in unrelated industries.

4/4/2013

59

1(3) Operating synergy


The theory is based on operating synergy assumes that economies of scale do exist in the industry and that prior to the merger, the firms are operating at levels of activity that fall short of achieving the potentials for economies of scale. It includes the concept of complementarities of capabilities

4/4/2013

60

Operating synergy continued


For e.g.: one firm might be strong in R&D but weak in marketing while another has a strong marketing department without the R&D capability. Merging the two firms would result in operating synergy.

4/4/2013

61

1(4) Pure diversification


The firm may simply lack internal growth opportunities for lack of requisite resources or due potential excess capacity in the industry.
Pure diversification as a theory of mergers differs from share holders portfolio diversification.

4/4/2013

62

Pure diversification continued


Therefore, firms may diversify to encourage firm-

specific human capital investments which make


their employees more valuable and productive. and to increase the probability that the organization and reputation of the firm will be preserved by

transfer to another line of business owned by the


firm in the event its initial business declines.
4/4/2013 63

1(5) Strategic realignment (repositioning) to changing environments


It says that mergers take place in response to environmental changes. External acquisitions of needed capabilities allow firms to adapt more quickly and with less risk than developing capabilities internally. Rationale is that by mergers the firm acquires management skills for needed increase of its present capabilities.
4/4/2013 64

1(6) Undervaluation
It states that mergers occur when the market

value of target firm stock for some reason does


not reflect its true or potential value in the hands of an alternative management. One possibility of undervaluation may be that management is not operating the company up to its potential.
4/4/2013 65

Undervaluation continued
A second possibility is that the acquirers have inside information. It is not much different from the inefficient

management or differential efficiency theory. it


cannot stand alone and requires an efficiency rationale.

4/4/2013

66

Efficiency theory
It aims to achieve synergies. Three types of synergies : 1. Financial Synergy: to achieve lower cost of capital through lowering the systematic risk of the acquirer, lower tax (Debt/equity ratio), cost reduction ( economies of scale),

2. Operational Synergy: To achieve operational excellence from a combined firms operations.


3. Managerial Synergy: To enhance a targets competitive position by transferring management expertise from the bidder to the target.
4/4/2013 67

2.Monopoly theory
It viewed that acquisition were executed to achieve market power. 3 ways of doing it: 1. Conglomerates use it to cross subsidies products 2. To limit competition in more than one market 3. To discourage the potential entrance of competitors into its market.

4/4/2013

68

3. Valuation theory
Acquisition being executed by managers, have superior information than the stock market about their exact targets unrealized potential value The acquirer possesses valuable and unique information to enhance the value of a combined firm through purchasing an undervalued target. LBO can be fit in this category. LBO signifies the acquisition of a business with the help of debt capital or borrowed capital.

4/4/2013

69

4.Empire-building theory
It holds that managers maximise their personal goals

Than their shareholder's value maximization through acquisition.

4/4/2013

70

5.Process theory
Strategic decisions are outcomes of processes governed by bounded rational theory Central role of organization routine Political power Rather than rational choices.

4/4/2013

71

6.Raider Theory
Raider is a person who causes wealth transfer from the shareholders of a target firm to the shareholders of the acquiring firm. One of the wealth transfer media is lavish compensation after a successful acquisition transaction, called golden parachute.

4/4/2013

72

7.Disturbance theory
It holds that the motives of acquisitions occur as a result of economic disturbances (ED).

ED cause changes in individuals expectations and increase the general degree of uncertainty.

4/4/2013

73

8.Information and signaling


The tender offer sends a signal to the market that the target companys shares are undervalued. The offer may signal information to the target management which motivates them to become more efficient. The target managements response to the offer and the means of payment may also have signaling value. This theory attempts to explain why target shares seem to be permanently revalued upward even if the offer turns out to be unsuccessful. The merger offer disseminated information that the target shares are undervalued and the offer prompts the market to revalue those shares. 4/4/2013 74

No particular action by the target firm or any others is necessary to cause the revaluation.

Information and signaling continued

This is called sitting on a gold mine explanation (Bradley, Desai and Kim, 1983)
The other hypothesis is that the offer inspires target firm management to implement a more efficient business strategy on its own. No outside input other that the merger offer itself is required for the upward revaluation. This is called kick in the pants explanation.
4/4/2013 75

9.Agency problems
Agency problems may result from a conflict of interest between managers and shareholders and between shareholders and debt holders . Takeovers are viewed as the last resort to discipline self serving managers. Agency problems arise basically because contracts between managers (decision or control agents) and owners (risk bearers) cannot be enforced. May result from conflict of interest between managers and shareholders or between shareholders and debt holders
4/4/2013 76

Agency problems continued


An agency problem arises when managers own only a fraction of the ownership shares of the firm. This may cause managers to work less vigorously (strongly) than otherwise and consume more perquisites In large corporations with widely dispersed ownership, there is not sufficient resources to monitor the behavior of managers. Takeovers as a solution to agency problems (Fama & Jensen, 1983) Managerialism (Mueller 1969)
4/4/2013 77

Managerialism
Takeovers are a manifestation (sign) of the agency problem, not its solution.
Self serving managers embark on mergers to expand their empire and improve their own career prospects.

4/4/2013

78

10. Free cash flow hypothesis


Jensens Free cash flow hypothesis says that takeovers takes place because of the conflicts

between managers and shareholders over the


payout of free cash flows. He defines free cash flow as cash flow in excess of the amounts required to fund all the projects that have positive NPVs. Debt-for-stock exchange offers are viewed as a means of bonding the managers promise to pay out future cash flows to stakeholders.
4/4/2013 79

Free cash flow hypothesis continued


He states that such free cash flow must be paid out to shareholders if the firm is to be efficient and to maximize share price The payout of free cash flow reduces the amount of resources under the control of managers and reduces their power resulting in agency costs.

4/4/2013

80

11.Market power
Market power advocates claim that merger gains are

the result of increased concentration leading to


collusion and monopoly effects.

The theory posts that mergers take place to increase


their market share, means increasing the size of the firm relative to other firms in an industry.

4/4/2013

81

Market power continued..


An objection is often raised against permitting a firm to increase its market share by merger is that the result will be undue concentration in the

industry.
On contrary, some economists hold that increased

concentration is generally the result of active and


intense competition.
4/4/2013 82

12.Tax effects
Tax implications may be important to mergers , although they do not play a major role.

Carry over of net operating losses and tax credits, substitution of capital gains for ordinary incomes are among the tax motivation for mergers.
Carry over of net operating losses and tax credits: a firm with accumulated tax losses and tax credits can give positive earnings of another firm with which it is joined

4/4/2013

83

Tax effects continued


2 conditions to be met: Majority of the target corporation should be acquired in exchange for the stock of the acquiring firm. Secondly, the acquisition should have legitimate motives/ business purposes net operating losses: can be carried back 3 years and forward 15 years
4/4/2013 84

Tax effects continued


Substitution of capital gains for ordinary income: a mature firm with few internal investment opportunities can acquire a growth firm in order to substitute capital gains taxes for ordinary income taxes. The acquiring firm provides the necessary funds which otherwise would have to be paid out as dividends taxable as ordinary incomes.
4/4/2013 85

13.Redistribution hypothesis
Gains from a merger may come at the expense of other stakeholders in the firm.

appropriate stakeholders may include bond holders, government and organized labour. Value increases in mergers by redistribution among the stakeholders of the firm. Possible shifts are from debt holders to stock holders and from labor to stockholders.
4/4/2013 86

Merger and Acquisition as a Growth Strategy


Why do companies resort to M&A? Obvious answer is instantaneous quantum growth No. of growth strategy: Ansoffs Product market matrix The BCG matrix The grand strategy matrix Industry/product life cycle analysis

4/4/2013

87

Ansoff's product-market matrix


The Ansoff's product-market matrix helps to understand and assess marketing or business development strategy.

Any business, or part of a business can choose which strategy to employ, or which mix of strategic options to use.
Ansoffs product/market growth matrix suggests that a business attempts to grow depend on whether it markets new or existing products in new or existing markets.

This is one simple way of looking at strategic development options


4/4/2013 88

Ansoff's product-market matrix

4/4/2013

89

Ansoffs growth opportunities: Market penetration Market development Product development These are grouped as a Intensive growth opportunities by Kotler And diversification as a separate class of opportunities It consists of
Concentric diversification Horizontal diversification Conglomerate diversification

4/4/2013

90

Intensive Growth: Market penetration


Business focuses on increasing in selling existing products into existing markets through more aggressive marketing efforts. Activities like Expanding the dealer and retailer network Getting bigger space for retailers Launching attractive dealer, and consumer incentive/gifts scheme Launching heavy advertisement campaigns No one can escape Marketing wars between Pepsi and coke HLL & P&G, Vodafone, Bharti Airtel and RCOM

4/4/2013

91

Market development
Market development is the name given to a growth strategy where the business seeks to sell its existing products into new markets. There are many possible ways of approaching this strategy, including: New geographical markets; for example exporting the product to a new country New product dimensions or packaging: for example New distribution channels Different pricing policies to attract different customers or create new market segments Ex:cRecently Gujarat Tea Processor and Packers Ltd. (GTPPL), popularly known as Wagh Bakri Tea Group, launched its product in Mumbai and parts of Maharashtra

4/4/2013

92

Product development
Product development is the name given to a growth strategy where a business aims to introduce new products into existing markets. Improved products for its present market This strategy may require the development of new competencies and requires the business to develop modified products which can appeal to existing markets. Ex: HLL had launched Surf in India in 1959. Then In 1996 improved version Surf Excel Launch of Diet Coke/Diet Pepsi Launch of LCD TVs, Plasma TVs Launch of newer and better models of car Microsoft Nokia

4/4/2013

93

Diversification
Diversification is the name given to the growth strategy where a business markets new products in new markets. This is an inherently more risk strategy because the business is moving into markets in which it has little or no experience. For a business to adopt a diversification strategy, therefore, it must have a clear idea about what it expects to gain from the strategy and an honest assessment of the risks.

4/4/2013

94

Concentric Diversification
Seeking to ad new products that have technological or marketing synergies with the existing products. Launch of Tata Sumo and Indica by Tata Motors

4/4/2013

95

Horizontal Diversification
Seeking to add new products that could appeal to its present customers though technically unrelated to its present product line.

4/4/2013

96

Conglomerate Diversification
Seeking to add new products for new classes of customers with no relationship to the companys current technology.

ITC is into many unrelated business From cigarettes, hotels paper and paperboard, biscuits and flour(atta)

4/4/2013

97

Efficiency Theories
The differential efficiency theory says that more efficient firms will acquire less efficient firms and realize gains by improving their efficiency. Differential efficiency is likely to be a factor in mergers between firms in related industries. The inefficient management theory suggests that target management is so incompetent that virtually any management could do better. This could be an explanation for mergers between firms in unrelated industries. The operating synergy theory assumes economies of scale/scope and complementarity of capabilities.
4/4/2013 98

Efficiency Theories
The financial synergy theory emphasises complementarity in the availability of investment opportunities and internal cash flows.
Is diversification justified? Shareholders can diversify more easily.

But managers and other employees are at greater risk if the single industry in which their firm operates should fail.

Firms may diversify to encourage firm specific human capital investments which make their employees more valuable and productive.

The organization and reputation capital of the firm is more likely to be preserved by transfer to another line of business in the event there is a decline in the prospects for the earlier business.

4/4/2013

99

Efficiency Theories (Contd)


The theory of strategic alignment to changing environments says that mergers take place in response to environmental changes.

External acquisitions of needed capabilities allow firms to adapt more quickly and with less risk than developing capabilities internally.
The undervaluation theory states that mergers occur when the market value of the target firm stock for some reason does not reflect its true or potential value or its value in the hands of alternative management. Firms may be able to acquire assets for expansion more cheaply by buying the stocks of existing firms than by buying or building assets when the targets stock price is below the replacement cost of its assets.
4/4/2013 100

Information/Signaling Theory
The tender offer sends a signal to the market that the target companys shares are undervalued.
The offer may signal information to the target management which motivates them to become more efficient. The target managements response to the offer and the means of payment may also have signaling value.

4/4/2013

101

Market Power
Market gains are the results of increased concentration leading to collusion and monopoly effects. But anti trust authorities are on the follow.

So these kinds of gains are becoming increasingly difficult.


4/4/2013 102

VALUE EFFECTS OF M&As


VALUE INCREASING THEORIES Transaction costs organization of firm is reaction to appropriate balance of internal operations and external markets Mergers create synergies Economies of scale More effective management target inadequate mgr. capabilities (horizontal), Improved production techniques Combination of complementary resources
4/4/2013 103

VALUE EFFECTS OF M&As


VALUE INCREASING THEORIES
Takeovers are disciplinary Can be used to remove poor managers - target incompetent mgt. (conglomerate) Facilitate competition between different management teams Undervaluation of target Target having more worth than actually valued Difference between the MV of assets and their replacement costs
4/4/2013 104

VALUE EFFECTS OF M&As


VALUE REDUCING THEORIES Agency costs of free cash flow Free cash flow is a source of value reducing mergers

Firms with FCF are those where internal funds exceed investment required for positive NPV projects

4/4/2013

105

VALUE EFFECTS OF M&As


VALUE REDUCING THEORIES Managerial entrenchment Managers hesitant to distribute cash to shareholders

Investments may be in form of acquisitions where managers over pay but reduce likelihood of their own replacement

4/4/2013

106

VALUE EFFECTS OF M&As


VALUE NEUTRAL THEORY HUBRIS Economic gains are not motives for M & A Merger bids result from managerial hubris managers are prone to excessive self confidence

Factors that result in the hubris spirit desire to avoid a loss of face, media praise, urge to project as an aggressive firm, inexperience, overestimation of the synergies, overenthusiastic investment banker etc.
4/4/2013 107

VALUE EFFECTS OF M&As


VALUE NEUTRAL THEORY HUBRIS Winners curse Competitive bidding has a distribution of value estimates Manager with most optimistic forecast wins bidding process Cursed by fact that bid likely overvalues target Mergers can occur even when no value effects: target sells when bid is higher than target value
4/4/2013 108

VALUE EFFECTS OF M&As


Principle Theory Value Transaction cost efficiency mergers optimize Increasing transaction costs Synergy scale, best practices, etc. Disciplinary takeovers can be used to replace poor management Undervaluation more worth, replacement costs Value Agency costs of free cash flow managers Reducing reinvest FCF inefficiently back into firm Management entrenchment firm invests to increase managers value to shareholders Value Neutral
4/4/2013

Hubris winner of takeover contest is firm that most overvalues target

109

PATTERNS OF GAINS IN M&As


Theory Efficiency/ Synergy Agency Costs/ Entrenchme nt
Hubris
4/4/2013

Combined Gains to Gains Target Positive Positive

Gains to Bidder NonNegative

Negative

Positive

More Negative
Negative
110

Zero

Positive

THE MERGER PROCESS


Examples demonstrate many complexities in negotiating deals
Bidder considerations: Pay cash or stock Deal with management or shareholders Buy initial stake or toehold Target considerations: Decision to sell Decision to seek competing bids or seek termination fee in initial bid
4/4/2013 111

MODELS OF TAKEOVER BIDDING The winners curse bidder in takeover risk overpaying
Bidders can shade bids lower but risk losing possible deals Alternative:
If concerned about value of target, can offer stock Shares risk of combined firm between bidder and target

4/4/2013

112

MODELS OF TAKEOVER BIDDING


Bidder costs making bid is expensive
Preemptive bid
Bidder decides to make bid that precludes other bidders from making competing offer Target may receive higher price if there is a preemptive bidder

Termination fee bidder making formal offer often requires a termination fee in agreement Toehold
Use of toehold helps to recoup bidding costs Size of toehold is a function of expected synergies from the merger
4/4/2013 113

MODELS OF TAKEOVER BIDDING Seller decisions


Effects of bidder using toehold
May deter other firms from making competitive bids But, seller can counteract by designing a favorable auction

Effects of costly bidding


Selling firm bears most of bidding costs Implies that seller may gain by limiting the number of bidders
4/4/2013 114

Example of Takeover Auction: Outlet Communications


Owned and operated television stations Board engaged Goldman Sachs to aid in sale via auction (auction began 2/95)
80 firms contacted GS 45 signed confidentiality agreements and received nonpublic information By 5/95, 12 firms submitted preliminary bids ranging from $32 to $38 8 firms invited to perform extensive due diligence By 6/95, 5 had submitted definitive proposals
4/4/2013 115

Example of Takeover Auction: Outlet Communications


Highest bid was $42.25 by Renaissance Communications OC and RC signed a merger agreement Before deal completed, NBC offered bid of $47.25 OC approved competing bid Example illustrates:
Complexity of bidding process Sequential reduction of number of bidders Advantages of encouraging multiple bids
4/4/2013 116

Examples of the Merger Process

Reasons given for the merger


Economies of scale in PC industry Projected synergies of $2.5 billion Strategic response to conditions in computer and information technology sectors

Market reaction to 9/3/01 announcement


Hewlett-Packard declined 19% Compaq fell by 10%

4/4/2013

117

Examples of the Merger Process

Major events in the merger process


CEOs initiated discussion in June 2001 firms then undertook extensive due diligence Consulting firms McKinsey and Accenture were involved in the analysis of the merger Goldman Sachs (HP) and Salomon Smith Barney (Compaq) were engaged in July 2001, to provide financial advice Members of Hewlett and Packard families threatened to vote against the merger Shareholders approve in May 2002

4/4/2013

118

Examples of the Merger Process

Deal began as a hostile bid by Northrop and evolved into merger Reasons given for the merger
Economies of scale in defense industry Complementary product mix

Market reaction to initial announcement (2/22/02)


TRW increased 26.4% (speculation that there may be more potential bidders, or that TRW would get a higher price from NG ) NG dropped by 6.7%

4/4/2013

119

Examples of the Merger Process

Major events in the merger process


2/22/02 Northrop releases letter sent to TRW proposing a merger 3/3/02 TRW rejected $47 stock offer TRW sought other bidders and considered implementing a split-up Northrop increased offer 7/2/02 announced merger agreement for $60 stock

4/4/2013

120

Example of the Bidding Process: Savannah Foods (a sugar refiner)


Merger process began in March 1996
SFs board of directors requested management develop a plan to improve shareholder value Plan: maximize value of core sugar business and consider acquisitions in related areas Discussions with acquisition candidates and merger partners in summer 1996 produced no formal actions

4/4/2013

121

Example of the Bidding Process: Savannah Foods (a sugar refiner)


Savannah discussed merger with two possible partners in late 1996 Flo-Sun reached deal to buy SF (7/15/97)
Shareholders of SF to own 41.5% of new entity SF price fell 15.7% to $15.75 at announcement Shareholder lawsuits arose over terms

Imperial Holly, a sugar refining company, made a competing bid


IH contacted investment banking firm, Lehman Brothers, to develop acquisition strategies IH made competing offer for SF for $18.75 per share (70% in cash and 30% in stock)
4/4/2013 122

Example of the Bidding Process: Savannah Foods (a sugar refiner)


Flo-Sun upped bid on 9/4/1997
SF would own 45% of new firm Shareholders would also receive $4 in cash

SF asked both bidders to submit final offers on 9/8/97


IH upped bid to $20.25 per share Flo-sun stood by most recent offer

SF executed merger agreement with IH on 9/12/97


Ended previous agreement with Flo-Sun Paid $5 million termination fee to Flo-Sun
4/4/2013 123