Ch26 Mergers and Acquisitions 6 Per Page

Chapter 26: Mergers and Acquisitions



Table of contents

The Legal Forms of Acquisition

Taxes 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



Merger versus Consolidation

Merger

One rm is acquired by another. Acquiring rm (acquirer) retainsname and acquired rm (acquired) cease to exist.

Advantage - simple to organize and cheaper than thealternatives

Disadvantage - must be approved by shareholders of bothrms; gaining approval can be slow and costly

ConsolidationEntirely new rm is emerged from combination of existing rms.



Acquisitions

An acquisition of stock is the purchase by one rm of acontrolling stake (voting stakes) in another rm

This can be done as a public oer to buy the shares on themarket (a tender oer) of another rm

shareholder approval for the deal is not required, the managersof the target rm are not necessarily consulted and theacquisition can be unfriendly (hostile)

An acquisition of assets is the purchase of the assets ofanother rm - it has the similar eect as an acquisition ofstock but the target rm does not necessarily cease to exist.



Acquisitions

Three most frequently observed types of activity are

1. Horizontal: both rms are in the same industry; create onelarge rm that occupies more dominant market position

2. Vertical: rms are in dierent stages of the production process

3. Conglomerate: rms are unrelated



Takeovers

TakeoverA general (and imprecise) term referring to the transfer of controlof a rm from one group to another.

Possible forms of takeovers Acquisition

Merger and Consolidation Acquisition of stock Acquisition of assets

Proxy Contest

Going Private

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MaiTypewriterA 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.

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MaiTypewriter=> both types of reorganization as mergers

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MaiTypewritervotes 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.

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

MaiTypewritera general mailing is used in a tender offer.

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MaiTypewriterthey are not required to accept it and need not tender their shares.

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MaiTypewriterA formal vote of the target stockholders is required in an acquisition of assets.

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MaiTypewritertakeovers encompass a broader set of activities than acquisitions

MaiTypewriterProxy 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.

MaiTypewriterIn 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.

MaiTypewriterEX: 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

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Taxes and Acquisitions

Taxes

Taxable acquisition

Firm purchased with cash

Capital gains taxes - shareholders of target may require ahigher price to cover the taxes

Assets are revalued - aects deprecation expenses

Tax-free acquisition

Business purpose; not solely to avoid taxes

Continuity of equity interest - target shareholders must beable to maintain an equity interest in the combined rm

Generally, stock for stock acquisition


Accounting For Acquisitions

Accounting for Acquisitions

Pooling of interests accounting no longer allowed Purchase accounting

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 andtreated as an expense if the market value of the assets hasdecreased



Synergy

Synergy

The positive incremental net gain associated with the combinationof two rms through a merger or acquisition

Some mergers create synergies because the rm can either cutcosts or use the combined assets more productively

This is generally a good reason for a merger

Examine whether the synergies create enough benet to justify thecost



Synergy

Let rm A be the acquirer, rm B be the target, and rm AB bethe combined rm following an acquisition. Firm values aredenoted, in this order, by VA, VB , and VAB .

A successful merger requires that the value of the combined exceedthe sum of the parts

VAB > VA + VB

The synergy gain is

VAB = VAB (VA + VB) > 0



Source of Synergy

Synergy is obtained from four main sources

1. increased revenue

2. decreased costs

3. reduced corporate taxes

4. lower cost of capital



Revenue Enhancement

Marketing gains

Advertising

Distribution network

Product mix

Strategic benets

Joined technology

Entry into new markets

Market power

Reduce/eliminate competition

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DELLTypewriterincremental net gain

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MaiTypewriterImprovements in at least one of these four categories create synergy

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MaiTypewriterCFt = Rev - Costs - Taxes - Capital Requirements

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MaiTypewriterAre 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.

MaiTypewriterHow 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.

MaiTypewriterA combined firm may generate greater revenues than two separate firms. Increased revenues can come from marketing gains, strategic benefits, and market power.

MaiTypewriterMarketing: mergers and acquisitions can increase operating revenues. Improvements can be made in the following areas: 1. Previously ineffective media programming and advertising efforts. 2. A weak existing distribution network. 3. An unbalanced product mix.

MaiTypewriter=> 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.

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MaiTypewriterThe increase in value from writing up assets is considered a taxable gain.

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Cost Reductions

Economies of scale

Average production costs decrease as production increase

Most common in industries that have high xed costs

Best in horizontal mergers

Economies of vertical integration

Coordinate operations more eectively

Reduced search costs for suppliers or customers

Complimentary resources

Make better use of existing resources



Taxes and Financial Synergy

Use of accumulated tax losses High income rm combining with a rm with operating losses

or large unused tax deductions Combined rm has enough income to use tax losses or

deductions

Use of unused debt capacity Finance acquisition with debt Increase tax shield and reduce WACC



Reducing Capital Needs and Cost of Capital

A merger may reduce the required investment in workingcapital and xed assets relative to the two separately operatedrms

Some assets may be sold if they become redundant in thecombined rm

Larger rms have better access to capital markets and greaterliquidity (economies of scale)

Combined rm may result in less-volatile cash ows, hencelower default risk and lower cost of capital



Motives for M&A

Eliminating ineciencies Operational ineciencies Managerial ineciencies

Expansion

Managerial ambition

EPS growth



EPS Growth

Mergers may create the appearance of growth in earnings pershare

If there are no synergies or other benets to the merger, thenthe growth in EPS is just an artifact of a larger rm and isnot true growth

In this case, the P/E ratio should fall because the combinedmarket value should not change

There is no free lunch



Example - EPS Growth

Consider two rms, A and B who are planning to merger using anissue of new rm A stock. Assume there are no economic ornancial synergy gains from the deal.

Firm A Firm B Combined Firm ABMarket Value (MV) 4,000,000 2,000,000 6,000,000Earnings 200,000 200,000 400,000Number of shares 100,000 100,000 150,000outstanding (N)Price per share (P) 40 20 40EPS(E) 2 2 2.667P/E ratio (PE) 20 10 15

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DELLTypewriterA or B leverage ratio below optimal => raise debt=> invest to buy another firm

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DELLTypewriter=> benefit of leverage: tax and cost of capital

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DELLTypewriterdiversification

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DELLTypewriter= 400,000/150,000

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DELLTypewriter= 6,000,000/150,000

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MaiTypewriter=> Economies from vertical integration probably explain why most airline companies own airplanes. They also may explain why some airline companies have purchased hotels and car rental companies.

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MaiTypewriterTechnology 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.

MaiTypewriterA ski equipment store merging with a tennis equipment store will smooth sales over both the winter and summer seasons, thereby making better use of store capacity

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MaiTypewriterTable 29.1

MaiTypewriter- Too little debt reduces firm value

MaiTypewriter - A firm with little or no debt is an inviting target => An acquirer could raise the targets debt level after the merger to create a bigger tax shield.

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MaiTypewriter=> economies of scale

MaiTypewriter=> Capital requirements: fixed capital and working capital.

MaiTypewriterCase 2: Increased Debt CapacityBecause the risk of the combined firm is less than that of either one separately,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.In other words, the risk reduction that the merger generates leads to greater debt capacity.

MaiTypewriterEX:For example, imagine that each firm can borrow $100 on its own before the merger. Perhaps the combined firm after the merger will be able to borrow $250 => Debt capacity has increased by $50 ($250 $200).

MaiTypewriter=> If debt rises after the merger, taxes will fall. In other words, the increased debt capacity from a merger can reduce taxes.

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MaiTypewriterDebt CapacityDebt Capacity Debt Capacity: case 1 & 2To summarize, we first considered the case where the target had too little leverage. => The acquirer could infuse the target with more debt, generating a greater tax shield. Next, we considered the case where both target and acquirer began with optimal debt levels. A merger leads to more debt even here. That is, the risk reduction from the merger creates greater debt capacity and thus a greater tax shield

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MaiTypewriterTwo Bad Reasons for Mergers

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MaiTypewriter- a share of B is selling for 50 percent ( $20/$40) of the price of a share of A

MaiTypewriter=> 0.5 x 100 shares B = 50 shares A

MaiTypewriteror = 6,000,000/400,000 = 15

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MaiTypewriter- 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

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MaiTypewriterFirm As P/E should drop when it takes on a new division with low growth.

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Exmaple - EPS Growth

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

This is called the Bootstrap eect

The gain is really an illusion, there are no economic ornancial gains in the merger and the P/E ratio has actuallydroped

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



Diversication

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

Shareholders can normally diversify their own portfoliocheaper than a rm can diversify by acquisition

Shareholder wealth may actually decrease after the mergerbecause the reduction in risk, in eect, transfers wealth fromthe shareholders to the bondholders



General Rules

Do not rely on book values alone - the market providesinformation about the true worth of assets

Estimate only incremental cash ows

Use an appropriate discount rate

Take into account transaction costs - these can add upquickly and become a substantial cash outow



Acquisition Gains and Costs

Evaluating an acquisition is just like evaluating any otherinvestment

It should only go ahead if the gain exceeds the cost, hence apositive NPV project

The gain is the dierence between the merged rm and thesum of the values of the separate rms (the synergy)



Cash Acquisition

The NPV of a cash acquisition is

NPV = V B Cash Cost to Firm A

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

The post-merger value of the combined rm (after paying thecash cost) is

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



Merger Premium

We can rewrite the NPV of an acquisition as

NPV = V + VB Cash Cost = V (Cash Cost VB)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 theCost of the acquisition.

The cost (premium) in a cash bid is the observed marketpremium paid over the market value of rm B plus thedierence between the market and intrinsic values of B

Cost = (Cash CostMVB) + (MVB VB) Caveat: tell the dierence between the market value (MV ) of

a rm and its intrinsic value (V )

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MaiTypewriterThe NPV of a Merger

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MaiTypewriter- the bondholders are likely to gain from the merger because their debt is now insured by two firms, not just one

MaiTypewriter - 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

MaiTypewriter- Stockhonderl: an individual benefits from portfolio diversification, diversification from a merger may actually hurt the stockholders.

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MaiTypewriterGain > cost => mean synergy

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Example: Cash Acquisition

Data: two rms A and B with VA = $200M, VB = $50M NA = 4M,PA = $50 VAB = $275M,Cash = $65M

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

PA =(275 65)

4= $52.5



Cash Acquisition

However, rm As share price may drop when the deal isannounced

If this happens, the market is sending a clear message thateither the merger benets are doubtful or that A is paying waytoo much for B

The market value of B may overstate its intrinsic value as aseparate entity (why and when?)

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



Stock Acquisition

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

depends on the number of new shares given to the targetshareholders (NN)

depends on the price of the combined rms stock post-mergerPAB

Cost = NN PAB VB



Example: Stock Acquisition

Firm A has 4M shares outstanding (NA) and it oers another1.3M 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 !

PAB = 275/(4 + 1.3) = $51.89 > $50

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?



Stock versus Cash Acquisition

Considerations when choosing between cash and stock:

Share gains - target shareholders dont participate in stockprice appreciation with a cash acquisition

Taxes - cash acquisitions are generally taxable

Control rights - cash acquisition do not dilute control rights


Defensive Tactics

Defensive Tactics

Corporate charter Establishes conditions that allow for a takeover Super-majority voting requirement

Targeted repurchase (a.k.a. greenmail)

Standstill agreements

Poison pills (share rights plans)

Leverage buyouts

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

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DELLTypewriter=> OVERPAID

DELLTypewriterVALUE THE COMBINED FIRM SHARES

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MaiTypewriter= 275 - 65 = 210 (gain - cost)= 210 - 200 = 10 (NPV)

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MaiTypewriterValue of firm A after the acquisition = Value of combined firm - Cash paid

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

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MaiTypewriterP (AB) > P (A) & P(B)

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MaiTypewriter=> this percentage is above 50 percent. 2/3 majorities are common, though the number can be much higher.

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MaiTypewriter=> 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

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MaiTypewriter- 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.

MaiTypewriter- 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.

MaiTypewriter=> issue debt to pay out a dividend

MaiTypewriter- 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.

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MaiTypewriter- Leverage buyout: Going-private transactions in which a large percentage of the money used to buy the outstanding stock is borrowedor 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

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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



Evidence on Acquisitions I

Target shareholders tend to earn excess returns in a merger

Target shareholders gain more in a tender oer than in astraight merger

Target rm managers have a tendency to oppose mergers,thus driving up the tender price



Evidence on Acquisitions II

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

Anticipated gains from mergers may not be achieved

Bidding rms are generally larger, so it takes a larger dollargain to generate the same percentage gain

Management may not be acting in the best interest ofshareholders

Takeover market may be competitive

Announcement may not contain new information about thebidding rm



Origin of the Benets

The gains received by the target rm are usually greater thanthe 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 realizethat the target was undervalued

The tax eect theory: there can be tax benets but thesedepend on the country



Origin of the Benets

The Hubris Hypothesis (Roll (1986))

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

The value of the oer premium signicantly overstates theincrease in economic value (the synergy), resulted from thecombination of the rms and this is the only real source ofgains in the acquisition process




Divestiturerm sells a piece of itself to another rm

Equity carve-out

rm creates a new rm out of a subsidiary and then sells aminority interest to the public through an IPO

Spin-o

rm creates a new rm out of a subsidiary and distributes theshares of the new rm to the parent companys shareholders

Split-up

rm is split into two or more rms, and shares of all rms aredistributed to the original rms shareholders

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MaiTypewritergain B > loss A

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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 maybe in shareholders best interest, and which generally are not?

What are some of the defensive tactics that rms use tothwart takeover?

How can a rm restructure itself? How do these methodsdier in terms of ownership?

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Ch26 Mergers and Acquisitions 6 Per Page