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Chapter 25

Mergers and Acquisitions

Key Concepts and Skills
Be able to define the various terms
associated with M&A activity
Understand the various reasons for
mergers and whether or not those reasons
are in the best interest of shareholders
Understand the various methods for a
paying for an acquisition
Understand the various defensive tactics
that are available
Chapter Outline
The Legal Forms of Acquisitions
Taxes and Acquisitions
Accounting for Acquisitions
Gains from Acquisition
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition
Defensive Tactics
Some Evidence on Acquisitions: Does M&A
Divestitures and Restructurings 25-2
Merger versus Consolidation
One firm is acquired by another
Acquiring firm retains name and acquired firm
ceases to exist
Advantage legally simple
Disadvantage must be approved by
stockholders of both firms
Entirely new firm is created from combination
of existing firms

A firm can be acquired by another firm or individual(s)
purchasing voting shares of the firms stock
Tender offer public offer to buy shares
Stock acquisition
No stockholder vote required
Can deal directly with stockholders, even if management is
May be delayed if some target shareholders hold out for more
money complete absorption requires a merger
Horizontal both firms are in the same industry
Vertical firms are in different stages of the production process
Conglomerate firms are unrelated

Control of a firm transfers from one group
to another
Possible forms
Merger or consolidation
Acquisition of stock
Acquisition of assets
Proxy contest
Going private

Tax-free acquisition
Business purpose; not solely to avoid taxes
Continuity of equity interest stockholders of target
firm must be able to maintain an equity interest in the
combined firm
Generally, stock for stock acquisition
Taxable acquisition
Firm purchased with cash
Capital gains taxes stockholders of target may
require a higher price to cover the taxes
Assets are revalued affects depreciation expense

Accounting for Acquisitions
Pooling of interests accounting no longer allowed
Purchase Accounting
Assets of acquired firm must be reported at
fair market value
Goodwill is created difference 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
The whole is worth more than the sum of
the parts
Some mergers create synergies because
the firm can either cut costs or use the
combined assets more effectively
This is generally a good reason for a
Examine whether the synergies create
enough benefit to justify the cost
Revenue Enhancement
Marketing gains
Distribution network
Product mix
Strategic benefits
Market power

Cost Reductions
Economies of scale
Ability to produce larger quantities while
reducing the average per unit cost
Most common in industries that have high
fixed costs
Economies of vertical integration
Coordinate operations more effectively
Reduced search cost for suppliers or
Complimentary resources
Take advantages of net operating losses
Carry-backs and carry-forwards
Merger may be prevented if the IRS believes the sole
purpose is to avoid taxes
Unused debt capacity
Surplus funds
Pay dividends
Repurchase shares
Buy another firm
Asset write-ups

Reducing Capital Needs
A merger may reduce the required
investment in working capital and fixed
assets relative to the two firms operating
Firms may be able to manage existing
assets more effectively under one umbrella
Some assets may be sold if they are
redundant in the combined firm (this
includes human capital as well)
General Rules
Do not rely on book values alone the
market provides information about the true
worth of assets
Estimate only incremental cash flows
Use an appropriate discount rate
Consider transaction costs these can
add up quickly and become a substantial
cash outflow

EPS Growth
Mergers may create the appearance of
growth in earnings per share
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
In this case, the P/E ratio should fall
because the combined market value
should not change
There is no free lunch 25-14
Diversification, in and of itself, is not a
good reason for a merger
Stockholders can normally diversify their
own portfolio cheaper than a firm can
diversify by acquisition
Stockholder wealth may actually decrease
after the merger because the reduction in
risk in effect transfers wealth from the
stockholders to the bondholders
Cash Acquisition
The NPV of a cash acquisition is
NPV = VB* cash cost
Value of the combined firm is
VAB = VA + (VB* - cash cost)
Often, the entire NPV goes to the target
Remember that a zero-NPV investment is
also desirable

Stock Acquisition
Value of combined firm
VAB = VA + VB + V
Cost of acquisition
Depends on the number of shares given to the target
Depends on the price of the combined firms stock
after the merger
Considerations when choosing between cash
and stock
Sharing gains target stockholders dont participate in
stock price appreciation with a cash acquisition
Taxes cash acquisitions are generally taxable
Control cash acquisitions do not dilute control

Defensive Tactics
Corporate charter
Establishes conditions that allow for a
Supermajority voting requirement
Targeted repurchase aka greenmail
Standstill agreements
Poison pills (share rights plans)
Leveraged buyouts

More (Colorful) Terms
Golden parachute
Poison put
Crown jewel
White knight
Shark repellent
Bear hug
Fair price provision
Dual class capitalization
Countertender offer
Evidence on Acquisitions
Shareholders of target companies tend to earn excess
returns in a merger
Shareholders of target companies gain more in a tender offer
than in a straight merger
Target firm managers have a tendency to oppose mergers, thus
driving up the tender price
Shareholders of bidding firms earn a small excess return
in a tender offer, but none in a straight merger
Anticipated gains from mergers may not be achieved
Bidding firms are generally larger, so it takes a larger dollar gain
to get the same percentage gain
Management may not be acting in stockholders best interest
Takeover market may be competitive
Announcement may not contain new information about the
bidding firm
Divestitures and Restructurings
Divestiture company sells a piece of itself to
another company
Equity carve-out company creates a new
company out of a subsidiary and then sells a
minority interest to the public through an IPO
Spin-off company creates a new company out
of a subsidiary and distributes the shares of the
new company to the parent companys
Split-up company is split into two or more
companies and shares of all companies are
distributed to the original firms shareholders