Mergers and acquisitions (encyclopedia of small business) study guide & homework help e notes

1/18/13 Mergers and Acquisitions (Encyclopedia of Small Business) Study Guide & Homework Help - eNotes.com

www.enotes.com/mergers-and-acquisitions-reference/mergers-acquisitions-178613/print 1/12

Mergers and Acquisitions

Search Mergers and Acquisitions Search

Mergers and Acquisitions

A merger occurs when one firm assumes all the assets and all the liabilities ofanother. The acquiring firm retains its identity, while the acquired firm ceases toexist. A majority vote of shareholders is generally required to approve a merger. Amerger is just one type of acquisition. One company can acquire another in severalother ways, including purchasing some or all of the company's assets or buying upits outstanding shares of stock.

In general, mergers and other types of acquisitions are performed in the hopes ofrealizing an economic gain. For such a transaction to be justified, the two firmsinvolved must be worth more together than they were apart. Some of the potentialadvantages of mergers and acquisitions include achieving economies of scale,combining complementary resources, garnering tax advantages, and eliminatinginefficiencies. Other reasons for considering growth through acquisitions includeobtaining proprietary rights to products or services, increasing market power bypurchasing competitors, shoring up weaknesses in key business areas, penetratingnew geographic regions, or providing managers with new opportunities for careergrowth and advancement. Since mergers and acquisitions are so complex, however,it can be very difficult to evaluate the transaction, define the associated costs andbenefits, and handle the resulting tax and legal issues.

"In today's global business environment, companies may have to grow to survive,and one of the best ways to grow is by merging with another company or acquiringother companies," consultant Jacalyn Sherriton told Robert McGarvey in aninterview for Entrepreneur. "Massive, multibillion-dollar corporations arebecoming the norm, leaving an entrepreneur to wonder whether a merger ought tobe in his or her plans, too," McGarvey continued.

When a small business owner chooses to merge with or sell out to another



company, it is sometimes called "harvesting" the small business. In this situation,the transaction is intended to release the value locked up in the small business forthe benefit of its owners and investors. The impetus for a small business owner topursue a sale or merger may involve estate planning, a need to diversify his or herinvestments, an inability to finance growth independently, or a simple need forchange. In addition, some small businesses find that the best way to grow andcompete against larger firms is to merge with or acquire other small businesses.

In principle, the decision to merge with or acquire another firm is a capitalbudgeting decision much like any other. But mergers differ from ordinaryinvestment decisions in at least five ways. First, the value of a merger may dependon such things as strategic fits that are difficult to measure. Second, theaccounting, tax, and legal aspects of a merger can be complex. Third, mergersoften involve issues of corporate control and are a means of replacing existingmanagement. Fourth, mergers obviously affect the value of the firm, but they alsoaffect the relative value of the stocks and bonds. Finally, mergers are often"unfriendly."

TYPES OF ACQUISITIONS

In general, acquisitions can be horizontal, vertical, or conglomerate. A horizontalacquisition takes place between two firms in the same line of business. Forexample, one tool and die company might purchase another. In contrast, a verticalmerger entails expanding forward or backward in the chain of distribution, towardthe source of raw materials or toward the ultimate consumer. For example, an autoparts manufacturer might purchase a retail auto parts store. A conglomerate isformed through the combination of unrelated businesses.

Another type of combination of two companies is a consolidation. In aconsolidation, an entirely new firm is created, and the two previous entities ceaseto exist. Consolidated financial statements are prepared under the assumption thattwo or more corporate entities are in actuality only one. The consolidatedstatements are prepared by combining the account balances of the individual firmsafter certain adjusting and eliminating entries are made.

Another way to acquire a firm is to buy the voting stock. This can be done byagreement of management or by tender offer. In a tender offer, the acquiring firmmakes the offer to buy stock directly to the shareholders, thereby bypassing



management. In contrast to a merger, a stock acquisition requires no stockholdervoting. Shareholders wishing to keep their stock can simply do so. Also, a minorityof shareholders may hold out in a tender offer.

A bidding firm can also buy another simply by purchasing all its assets. Thisinvolves a costly legal transfer of title and must be approved by the shareholders ofthe selling firm. A takeover is the transfer of control from one group to another.Normally, the acquiring firm (the bidder) makes an offer for the target firm. In aproxy contest, a group of dissident shareholders will seek to obtain enough votes togain control of the board of directors.

TAXABLE VERSUS TAX-FREE TRANSACTIONS

Mergers and acquisitions can be either tax-free or taxable events. The tax status ofa transaction may affect its value from both the buyer's and the seller's viewpoints.In a taxable acquisition, the assets of the selling firm are revalued or "written up."Therefore, the depreciation deduction will rise (assets are not revalued in a tax-freeacquisition). But the selling shareholders will have to pay capital gains taxes andthus will want more for their shares to compensate. This is known as the capitalgains effect. The capital gains and write-up effects tend to cancel each other out.

Certain exchanges of stock are considered tax-free reorganizations, which permitthe owners of one company to exchange their shares for the stock of the acquirerwithout paying taxes. There are three basic types of tax-free reorganizations. Inorder for a transaction to qualify as a type A tax-free reorganization, it must bestructured in certain ways. In contrast to a type B reorganization, the type Atransaction allows the buyer to use either voting or nonvoting stock. It also permitsthe buyer to use more cash in the total consideration since the law does notstipulate a maximum amount of cash that can be used. At least 50 percent of theconsideration, however, must be stock in the acquiring corporation. In addition, ina type A reorganization, the acquiring corporation may choose not to purchase allthe target's assets.

In instances where at least 50 percent of the bidder's stock is used as theconsiderationut other considerations such as cash, debt, or nonequity securities arealso usedhe transaction may be partially taxable. Capital gains taxes must be paidon those shares that were exchanged for nonequity consideration.



A type B reorganization requires that the acquiring corporation use mainly its ownvoting common stock as the consideration for purchase of the target corporation'scommon stock. Cash must comprise no more than 20 percent of the totalconsideration, and at least 80 percent of the target's stock must be paid for byvoting stock by the bidder.

Target stockholders who receive the stock of the acquiring corporation in exchangefor their common stock are not immediately taxed on the consideration theyreceive. Taxes will have to be paid only if the stock is eventually sold. If cash isincluded in the transaction, this cash may be taxed to the extent that it represents again on the sale of stock.

In a type C reorganization, the acquiring corporation must purchase 80 percent ofthe fair market value of the target's assets. In this type of reorganization, a taxliability results when the acquiring corporation purchases the assets of the targetusing consideration other than stock in the acquiring corporation. The tax liabilityis measured by comparing the purchase price of the assets with the adjusted basisof these assets.

FINANCIAL ACCOUNTING FOR MERGERS ANDACQUISITIONS

The two principal accounting methods used in mergers and acquisitions are thepooling of interests method and the purchase method. The main difference betweenthem is the value that the combined firm's balance sheet places on the assets of theacquired firm, as well as the depreciation allowances and charges against incomefollowing the merger.

The pooling of interests method assumes that the transaction is simply an exchangeof equity securities. Therefore, the capital stock account of the target firm iseliminated, and the acquirer issues new stock to replace it. The two firms' assetsand liabilities are combined at their historical book values as of the acquisitiondate. The end result of a pooling of interests transaction is that the total assets ofthe combined firm are equal to the sum of the assets of the individual firms. Nogoodwill is generated, and there are no charges against earnings. A tax-freeacquisition would normally be reported as a pooling of interests.



Under the purchase method, assets and liabilities are shown on the merged firm'sbooks at their market (not book) values as of the acquisition date. This method isbased on the idea that the resulting values should reflect the market valuesestablished during the bargaining process. The total liabilities of the combinedfirm equal the sum of the two firms' individual liabilities. The equity of theacquiring firm is increased by the amount of the purchase price.

Accounting for the excess of cost over the aggregate of the fair market values ofthe identifiable net assets acquired applies only in purchase accounting. The excessis called goodwill, an asset which is charged against income and amortized over aperiod that cannot exceed 40 years. Although the amortization "expense" isdeducted from reported income, it cannot be deducted for tax purposes.

Purchase accounting usually results in increased depreciation charges because thebook value of most assets is usually less than fair value because of inflation. Fortax purposes, however, depreciation does not increase because the tax basis of theassets remains the same. Since depreciation under pooling accounting is based onthe old book values of the assets, accounting income is usually higher under thepooling method. The accounting treatment has no cash flow consequences. Thus,value should be unaffected by accounting procedure. However, some firms maydislike the purchase method because of the goodwill created. The reason for this isthat goodwill is amortized over a period of years.

HOW TO VALUE AN ACQUISITION CANDIDATE

Valuing an acquisition candidate is similar to valuing any investment. The analystestimates the incremental cash flows, determines an appropriate risk-adjusteddiscount rate, and then computes the net present value (NPV). If firm A isacquiring firm B, for example, then the acquisition makes economic sense if thevalue of the combined firm is greater than the value of firm A plus the value offirm B. Synergy is said to exist when the cash flow of the combined firm is greaterthan the sum of the cash flows for the two firms as separate companies. The gainfrom the merger is the present value of this difference in cash flows.

SOURCES OF GAINS FROM ACQUISITIONS The gains from an acquisition mayresult from one or more of the following five categories:1) revenue enhancement,2) cost reductions, 3) lower taxes, 4) changing capital requirements, or 5) a lowercost of capital. Increased revenues may come from marketing gains, strategic



benefits, and market power. Marketing gains arise from more effective advertising,economies of distribution, and a better mix of products. Strategic benefitsrepresent opportunities to enter new lines of business. Finally, a merger mayreduce competition, thereby increasing market power. Such mergers, of course,may run afoul of antitrust legislation.

A larger firm may be able to operate more efficiently than two smaller firms,thereby reducing costs. Horizontal mergers may generate economies of scale. Thismeans that the average production cost will fall as production volume increases. Avertical merger may allow a firm to decrease costs by more closely coordinatingproduction and distribution. Finally, economies may be achieved when firms havecomplementary resourcesor example, when one firm has excess productioncapacity and another has insufficient capacity.

Tax gains in mergers may arise because of unused tax losses, unused debt capacity,surplus funds, and the write-up of depreciable assets. The tax losses of targetcorporations can be used to offset the acquiring corporation's future income. Thesetax losses can be used to offset income for a maximum of 15 years or until the taxloss is exhausted. Only tax losses for the previous three years can be used to offsetfuture income.

Tax loss carry-forwards can motivate mergers and acquisitions. A company thathas earned profits may find value in the tax losses of a target corporation that canbe used to offset the income it plans to earn. A merger may not, however, bestructured solely for tax purposes. In addition, the acquirer must continue tooperate the pre-acquisition business of the company in a net loss position. The taxbenefits may be less than their "face value," not only because of the time value ofmoney, but also because the tax loss carry-forwards might expire without beingfully utilized.

Tax advantages can also arise in an acquisition when a target firm carries assets onits books with basis, for tax purposes, below their market value. These assets couldbe more valuable, for tax purposes, if they were owned by another corporation thatcould increase their tax basis following the acquisition. The acquirer would thendepreciate the assets based on the higher market values, in turn, gaining additionaldepreciation benefits.

Interest payments on debt are a tax-deductible expense, whereas dividendpayments from equity ownership are not. The existence of a tax advantage for debt



is an incentive to have greater use of debt, as opposed to equity, as the means offinancing merger and acquisition transactions. Also, a firm that borrows much lessthan it could may be an acquisition target because of its unused debt capacity.While the use of financial leverage produces tax benefits, debt also increases thelikelihood of financial distress in the event that the acquiring firm cannot meet itsinterest payments on the acquisition debt.

Finally, a firm with surplus funds may wish to acquire another firm. The reason isthat distributing the money as a dividend or using it to repurchase shares willincrease income taxes for shareholders. With an acquisition, no income taxes arepaid by shareholders.

Acquiring firms may be able to more efficiently utilize working capital and fixedassets in the target firm, thereby reducing capital requirements and enhancingprofitability. This is particularly true if the target firm has redundant assets thatmay be divested.

The cost of debt can often be reduced when two firms merge. The combined firmwill generally have reduced variability in its cash flows. Therefore, there may becircumstances under which one or the other of the firms would have defaulted onits debt, but the combined firm will not. This makes the debt safer, and the cost ofborrowing may decline as a result. This is termed the coinsurance effect.

Diversification is often cited as a benefit in mergers. Diversification by itself,however, does not create any value because stockholders can accomplish the samething as the merger by buying stock in both firms.

VALUATION PROCEDURES The procedure for valuing an acquisition candidatedepends on the source of the estimated gains. Different sources of synergy havedifferent risks. Tax gains can be estimated fairly accurately and should bediscounted at the cost of debt. Cost reductions through operating efficiencies canalso be determined with some confidence. Such savings should be discounted at anormal weighted average cost of capital. Gains from strategic benefits are difficultto estimate and are often highly uncertain. A discount rate greater than the overallcost of capital would thus be appropriate.

The net present value (NPV) of the acquisition is equal to the gains less the cost ofthe acquisition. The cost depends on whether cash or stock is used as payment. Thecost of an acquisition when cash is used is just the amount paid. The cost of the



merger when common stock is used as the consideration (the payment) is equal tothe percentage of the new firm that is owned by the previous shareholders in theacquired firm multiplied by the value of the new firm. In a cash merger thebenefits go entirely to the acquiring firm, whereas in a stock-for-stock exchangethe benefits are shared by the acquiring and acquired firms.

Whether to use cash or stock depends on three considerations. First, if theacquiring firm's management believes that its stock is overvalued, then a stockacquisition may be cheaper. Second, a cash acquisition is usually taxable, whichmay result in a higher price. Third, the use of stock means that the acquired firmwill share in any gains from merger; if the merger has a negative NPV, however,then the acquired firm will share in the loss.

In valuing acquisitions, the following factors should be kept in mind. First, marketvalues must not be ignored. Thus, there is no need to estimate the value of apublicly traded firm as a separate entity. Second, only those cash flows that areincremental are relevant to the analysis. Third, the discount rate used should reflectthe risk associated with the incremental cash flows. Therefore, the acquiring firmshould not use its own cost of capital to value the cash flows of another firm.Finally, acquisition may involve significant investment banking fees and costs.

HOSTILE ACQUISITIONS

The replacement of poor management is a potential source of gain fromacquisition. Changing technological and competitive factors may lead to a need forcorporate restructuring. If incumbent management is unable to adapt, then a hostileacquisition is one method for accomplishing change.

Hostile acquisitions generally involve poorly performing firms in matureindustries, and occur when the board of directors of the target is opposed to the saleof the company. In this case, the acquiring firm has two options to proceed with theacquisition tender offer or a proxy fight. A tender offer represents an offer to buythe stock of the target firm either directly from the firm's shareholders or throughthe secondary market. In a proxy fight, the acquirer solicits the shareholders of thetarget firm in an attempt to obtain the right to vote their shares. The acquiring firmhopes to secure enough proxies to gain control of the board of directors and, inturn, replace the incumbent management.



Management in target firms will typically resist takeover attempts either to get ahigher price for the firm or to protect their own self-interests. This can be done anumber of ways. Target companies can decrease the likelihood of a takeoverthough charter amendments. With the staggered board technique, the board ofdirectors is classified into three groups, with only one group elected each year.Thus, the suitor cannot obtain control of the board immediately even though it mayhave acquired a majority ownership of the target via a tender offer. Under asupermajority amendment, a higher percentage than 50 percentenerally two-thirdsor 80 percents required to approve a merger.

Other defensive tactics include poison pills and dual class recapitalizations. Withpoison pills, existing shareholders are issued rights which, if a bidder acquires acertain percentage of the outstanding shares, can be used to purchase additionalshares at a bargain price, usually half the market price. Dual class recapitalizationsdistribute a new class of equity with superior voting rights. This enables the targetfirm's managers to obtain majority control even though they do not own a majorityof the shares.

Other preventative measures occur after an unsolicited offer is made to the targetfirm. The target may file suit against the bidder alleging violations of antitrust orsecurities laws. Alternatively, the target may engage in asset and liabilityrestructuring to make it an unattractive target. With asset restructuring, the targetpurchases assets that the bidder does not want or that will create antitrustproblems, or sells off the assets that the suitor desires to obtain. Liabilityrestructuring maneuvers include issuing shares to a friendly third party to dilutethe bidder's ownership position or leveraging up the firm through a leveragedrecapitalization making it difficult for the suitor to finance the transaction.

Other postoffer tactics involve targeted share repurchases (often termed"greenmail")n which the target repurchases the shares of an unfriendly suitor at apremium over the current market pricend golden parachuteshich are lucrativesupplemental compensation packages for the target firm's management. Thesepackages are activated in the case of a takeover and the subsequent resignations ofthe senior executives. Finally, the target may employ an exclusionary self-tender.With this tactic, the target firm offers to buy back its own stock at a premium fromeveryone except the bidder.

A privately owned firm is not subject to unfriendly takeovers. A publicly traded



firm "goes private" when a group, usually involving existing management, buys upall the publicly held stock. Such transactions are typically structured as leveragedbuyouts (LBOs). LBOs are financed primarily with debt secured by the assets ofthe target firm.

DO ACQUISITIONS BENEFIT SHAREHOLDERS?

There is substantial empirical evidence that the shareholders in acquired firmsbenefit substantially. Gains for this group typically amount to 20 percent inmergers and 30 percent in tender offers above the market prices prevailing a monthprior to the merger announcement.

The gains to acquiring firms are difficult to measure. The best evidence suggeststhat shareholders in bidding firms gain little. Losses in value subsequent to mergerannouncements are not unusual. This seems to suggest that overvaluation bybidding firms is common. Managers may also have incentives to increase firm sizeat the potential expense of shareholder wealth. If so, merger activity may happenfor noneconomic reasons, to the detriment of shareholders.

FURTHER READING:

Auerbach, Alan J. Corporate Takeovers: Causes and Consequences. Chicago:University of Chicago Press, 1988.

"Business For Sale: No Sure Thing." Inc. July 1999.

Coffee, John C., Jr., Louis Lowenstein, and Susan Rose-Ackerman. Knights,Raiders, and Targets: The Impact of the Hostile Takeover. New York: OxfordUniversity Press, 1988.

Gaughan, Patrick A. Mergers and Acquisitions. New York: Harper Collins, 1991.

Hoover, Kent. "Bill Would Aid Mergers of Small Businesses." SacramentoBusiness Journal. July 21, 2000.

Kilpatrick, Christine. "More Owners Put Small Businesses on the Sale Block." SanFrancisco Business Times. June 9, 2000.



McGarvey, Robert. "Merge Ahead: Before You Go Full-Speed into a Merger, ReadThis." Entrepreneur. October 1997.

Sherman, Andrew J. Running and Growing Your Business. New York: RandomHouse, 1997.

SEE ALSO: Leveraged Buyout

Source: Encyclopedia of Small Business, ©2002 Gale Cengage. All RightsReserved. Full copyright.

Did this raise a question for you?

Ask a Question

© 2013 eNotes.com, Inc. or its Licensors, All Rights Reserved.

http://ad.doubleclick.net/click%3Bh%3Dv8/3d6e/f/312/%2a/c%3B265628609%3B0-0%3B0%3B91010428%3B4307-300/250%3B51740643/51705836/1%3B%3B~okv%3D%3Bpc%3D%5BTPAS_ID%5D%3B%3B~sscs%3D%3fhttp://i.w55c.net/cl?t=1&btid=NTBGOUJDREUwMDAzQUQ3MTBBNDUwMUFCRDAwMDc3MTl8R0Z1dHJBY2ZJM3wxMzU4NTQ0MDk0Mjk5fDF8MEZTVU1Jbms2aXwwUllUSllFU3RRfDNiNGFmOGM5LTBhNGMtNGQyYy04ZWQ1LTE5ZDAyNWRlZGQzN3w0NTAwMDAwfHx8fHxVU0Q&ei=GOOGLE&tpc=http%3A%2F%2Fadclick.g.doubleclick.net%2Faclk%3Fsa%3Dl%26ai%3DCoj7S3rz5UPHaDquDlAKZ7oGADbXMvpQCj-3YlQ-1mZHTaBABIABQgMfhxARgyY74hsij_BqCARdjYS1wdWItMjYzMzIyNTUyNTkyNDU2OKABsbTV7APIAQngAgCoAwGqBLUBT9CESGUt5e4vADDjvde9tquVgk8cluPQGsbJYWE2iCVPFduH7v6c3KeiD5g6rtBhZ_rB12MZNRTd24DzTWzujt-4dguukHxNL01kdnmtO5hF1akl8Wh1bwXf1NgU52Fvy7HYmYO1_u9QvsuIpEVazOcUMQvEZeoWuGXxagtBa-9oCUMZDJ5YoZZiBykF9RZSOchaKexho5ehzUMMewN7ZEzE8CTNFAMVDtqb_gphOicl0HnGH-AEAYAG_P_y5Z_YjojpAQ%26num%3D1%26sig%3DAOD64_0da8BBOWhuxsgILqSmJMi_1G086Q%26client%3Dca-pub-2633225525924568%26adurl%3D&rurl=http%3a%2f%2fsuccess.adobe.com/en/na/sem/products/creativesuite/cloud.html%3Fsdid%3DKBOSB

http://pixel.quantserve.com/r?a=p-9fYuixa7g_Hm2;rand=71388;labels=_click.creative.iab,_qc.iab.clk.p-99Naa7xfIwC-w.20807.531969,_qc.template;redirecturl2=http://www.quantcast.com/adchoices

