M&A

Mergers and AcquisitionsMergers and Acquisitions

Types of TakeoversTypes of Takeovers


Mergers and Acquisitions

Types of TakeoversTypes of TakeoversGeneral GuidelinesGeneral Guidelines

TakeoverTakeover– The transfer of control from one ownership group to another.The transfer of control from one ownership group to another.

AcquisitionAcquisition– The purchase of one firm by anotherThe purchase of one firm by another

MergerMerger– The combination of two firms into a new legal entityThe combination of two firms into a new legal entity– A new company is createdA new company is created– Both sets of shareholders have to approve the transaction.Both sets of shareholders have to approve the transaction.

AmalgamationAmalgamation– A genuine merger in which both sets of shareholders must A genuine merger in which both sets of shareholders must

approve the transactionapprove the transaction– Requires a fairness opinion by an independent expert on the Requires a fairness opinion by an independent expert on the

true value of the firm’s shares when a public minority existstrue value of the firm’s shares when a public minority exists

• A A mergermerger is the complete absorption of one firm by another and in is the complete absorption of one firm by another and in this scenario we refer to an acquisition that takes place in friendly this scenario we refer to an acquisition that takes place in friendly termsterms

• The acquiring firm retains its identity and acquires all the assets and The acquiring firm retains its identity and acquires all the assets and liabilities of the acquired firm that ceases to exist and, thus, such liabilities of the acquired firm that ceases to exist and, thus, such transactions are also called transactions are also called acquisitionsacquisitions (e.g. the acquisition of (e.g. the acquisition of McDonnell Douglas by Boeing)McDonnell Douglas by Boeing)

• In a In a consolidationconsolidation, both firms cease to exist and a new firm is , both firms cease to exist and a new firm is created after the acquisition (e.g. Peco Energy and Unicom merged created after the acquisition (e.g. Peco Energy and Unicom merged to form the new utility firm Exelon)to form the new utility firm Exelon)

• In the typical merger, the stockholders of the ceased firm receive In the typical merger, the stockholders of the ceased firm receive either cash or shares in the surviving firmeither cash or shares in the surviving firm

• The acquiring firm makes an offer to the stockholders of the The acquiring firm makes an offer to the stockholders of the acquired (or target) firmacquired (or target) firm to purchase their shares through cash, or to purchase their shares through cash, or shares in the new firm or bothshares in the new firm or both

• Another form of an acquisition is for the acquiring firm to purchase Another form of an acquisition is for the acquiring firm to purchase all the assets of the acquired firmall the assets of the acquired firm, but this may be a costly , but this may be a costly procedureprocedure

• Acquisitions can beAcquisitions can be• HorizontalHorizontal: a firm acquires another firm in the same industry (Daimler : a firm acquires another firm in the same industry (Daimler

– Chrysler in 1998) – Chrysler in 1998)

• A merger in which two firms in the same industry combine.A merger in which two firms in the same industry combine.• Often in an attempt to achieve economies of scale and/or scopeOften in an attempt to achieve economies of scale and/or scope

• VerticalVertical: a firm acquires another firm in a different stage (backward or : a firm acquires another firm in a different stage (backward or forward) of the production process (GM - Fisher Body)forward) of the production process (GM - Fisher Body)

• A merger in which one firm acquires a supplier or another firm that is A merger in which one firm acquires a supplier or another firm that is closer to its existing customers.closer to its existing customers.

• Often in an attempt to control supply or distribution channels.Often in an attempt to control supply or distribution channels.

• ConglomerateConglomerate (merger): combination of two firms in unrelated (merger): combination of two firms in unrelated industries (Mobil Oil – Montgomery Ward in 1974) industries (Mobil Oil – Montgomery Ward in 1974)

• A merger in which two firms in unrelated businesses combine.A merger in which two firms in unrelated businesses combine.• Purpose is often to ‘diversify’ the company by combining uncorrelated assets and Purpose is often to ‘diversify’ the company by combining uncorrelated assets and

income streamsincome streams

• Cross-border (International) M&AsCross-border (International) M&As• A merger or acquisition involving a Canadian and a foreign firm a either the A merger or acquisition involving a Canadian and a foreign firm a either the

acquiring or target company.acquiring or target company.


• A A takeovertakeover is the purchase of one firm by is the purchase of one firm by another firmanother firm

• If the takeover is friendly, then it is basically an If the takeover is friendly, then it is basically an acquisition, but if not, then it is known as acquisition, but if not, then it is known as hostile hostile takeovertakeover (IBM’s acquisition of Lotus in 1995; (IBM’s acquisition of Lotus in 1995; Oracle’s bid for PeopleSoft in 2003)Oracle’s bid for PeopleSoft in 2003)



Types of TakeoversTypes of TakeoversHow the Deal is FinancedHow the Deal is Financed

Cash TransactionCash Transaction– The receipt of cash for shares by shareholders in the The receipt of cash for shares by shareholders in the

target company.target company.

Share TransactionShare Transaction– The offer by an acquiring company of shares or a The offer by an acquiring company of shares or a

combination of cash and shares to the target combination of cash and shares to the target company’s shareholders.company’s shareholders.

Going Private Transaction (Issuer bid)Going Private Transaction (Issuer bid)– A special form of acquisition where the purchaser A special form of acquisition where the purchaser

already owns a majority stake in the target company.already owns a majority stake in the target company.

Motives for TakeoversMotives for Takeovers



Mergers and Acquisition ActivityMergers and Acquisition Activity

• M&A activity seems to come in ‘waves’ M&A activity seems to come in ‘waves’ through the economic cycle domestically, or through the economic cycle domestically, or in response to globalization issues such as:in response to globalization issues such as:– Formation and development of trading zones or Formation and development of trading zones or

blocks (EU, North America Free Trade Agreementblocks (EU, North America Free Trade Agreement– DeregulationDeregulation– Sector booms such as energy or metalsSector booms such as energy or metals


Motivations for Mergers and AcquisitionsMotivations for Mergers and AcquisitionsCreation of Synergy Motive for M&AsCreation of Synergy Motive for M&As

The primary motive should be the creation of The primary motive should be the creation of synergy.synergy.

Synergy value is created from economies of Synergy value is created from economies of integrating a target and acquiring a integrating a target and acquiring a company; the amount by which the value of company; the amount by which the value of the combined firm exceeds the sum value of the combined firm exceeds the sum value of the two individual firms.the two individual firms.


Creation of Synergy Motive for M&AsCreation of Synergy Motive for M&As

Synergy is the additional value created (∆V) :Synergy is the additional value created (∆V) :

Where:Where:VVTT == the pre-merger value of the target firm the pre-merger value of the target firm

VVA - TA - T == value of the post merger firmvalue of the post merger firm

VVAA == value of the pre-merger acquiring firmvalue of the pre-merger acquiring firm

)V-(VVV TATA [ 15-1]


Value Creation Motivations for M&AsValue Creation Motivations for M&AsOperating SynergiesOperating Synergies

Operating SynergiesOperating Synergies1.1. Economies of ScaleEconomies of Scale

• Reducing capacity (consolidation in the number of firms in the Reducing capacity (consolidation in the number of firms in the industry)industry)

• Spreading fixed costs (increase size of firm so fixed costs per unit Spreading fixed costs (increase size of firm so fixed costs per unit are decreased)are decreased)

• Geographic synergies (consolidation in regional disparate Geographic synergies (consolidation in regional disparate operations to operate on a national or international basis) operations to operate on a national or international basis)

2.2. Economies of ScopeEconomies of Scope• Combination of two activities reduces costsCombination of two activities reduces costs

3.3. Complementary StrengthsComplementary Strengths• Combining the different relative strengths of the two firms creates Combining the different relative strengths of the two firms creates

a firm with both strengths that are complementary to one another. a firm with both strengths that are complementary to one another.


Value Creation Motivations for M&AValue Creation Motivations for M&A Efficiency Increases and Financing Synergies Efficiency Increases and Financing Synergies

Efficiency IncreasesEfficiency Increases– New management team will be more efficient and New management team will be more efficient and

add more value than what the target now has.add more value than what the target now has.– The combined firm can make use of unused The combined firm can make use of unused

production/sales/marketing channel capacityproduction/sales/marketing channel capacity

Financing SynergyFinancing Synergy– Reduced cash flow variabilityReduced cash flow variability– Increase in debt capacityIncrease in debt capacity– Reduction in average costsReduction in average costs– Fewer information problemsFewer information problems


Value Creation Motivations for M&AValue Creation Motivations for M&A Tax Benefits and Strategic Realignments Tax Benefits and Strategic Realignments

Tax BenefitsTax Benefits– Make better use of tax deductions and creditsMake better use of tax deductions and credits

• Use them before they lapse or expire (loss carry-back, carry-Use them before they lapse or expire (loss carry-back, carry-forward provisions)forward provisions)

• Use of deduction in a higher tax bracket to obtain a large tax shieldUse of deduction in a higher tax bracket to obtain a large tax shield• Use of deductions to offset taxable income (non-operating capital Use of deductions to offset taxable income (non-operating capital

losses offsetting taxable capital gains that the target firm was losses offsetting taxable capital gains that the target firm was unable to use) unable to use)

Strategic RealignmentsStrategic Realignments– Permits new strategies that were not feasible for prior to the Permits new strategies that were not feasible for prior to the

acquisition because of the acquisition of new management acquisition because of the acquisition of new management skills, connections to markets or people, and new skills, connections to markets or people, and new products/services.products/services.


Managerial Motivations for M&AsManagerial Motivations for M&As

Managers may have their own motivations to pursue Managers may have their own motivations to pursue M&As. The two most common, are not necessarily in M&As. The two most common, are not necessarily in the best interest of the firm or shareholders, but do the best interest of the firm or shareholders, but do address common needs of managersaddress common needs of managers

1.1. Increased firm sizeIncreased firm size– Managers are often more highly rewarded financially for building a Managers are often more highly rewarded financially for building a

bigger business (compensation tied to assets under administration for bigger business (compensation tied to assets under administration for example)example)

– Many associate power and prestige with the size of the firm.Many associate power and prestige with the size of the firm.

2.2. Reduced firm risk through diversificationReduced firm risk through diversification• Managers have an undiversified stake in the business (unlike Managers have an undiversified stake in the business (unlike

shareholders who hold a diversified portfolio of investments and don’t shareholders who hold a diversified portfolio of investments and don’t need the firm to be diversified) and so they tend to dislike risk need the firm to be diversified) and so they tend to dislike risk (volatility of sales and profits)(volatility of sales and profits)

• M&As can be used to diversify the company and reduce volatility (risk) M&As can be used to diversify the company and reduce volatility (risk) that might concern managers.that might concern managers.


Empirical Evidence of Gains through M&AsEmpirical Evidence of Gains through M&AsShareholder Value at Risk (SVAR)Shareholder Value at Risk (SVAR)

• Shareholder Value at Risk (SVAR)Shareholder Value at Risk (SVAR)– Is the potential in an M&A that synergies will not be Is the potential in an M&A that synergies will not be

realized or that the premium paid will be greater than realized or that the premium paid will be greater than the synergies that are realized.the synergies that are realized.• When using cash, the acquirer bears all the riskWhen using cash, the acquirer bears all the risk• When using share swaps, the risk is borne by the When using share swaps, the risk is borne by the

shareholders in both companiesshareholders in both companies

• SVAR supports the argument that firms SVAR supports the argument that firms making cash deals are much more careful making cash deals are much more careful about the acquisition price.about the acquisition price.

Valuation Issues in Corporate Valuation Issues in Corporate TakeoversTakeovers


Valuation IssuesValuation IssuesWhat is Fair Market Value?What is Fair Market Value?

Fair market value (FMV) is the highest price Fair market value (FMV) is the highest price obtainable in an open and unrestricted market obtainable in an open and unrestricted market between knowledgeable, informed and prudent between knowledgeable, informed and prudent parties acting at arm’s length, with neither party parties acting at arm’s length, with neither party being under any compulsion to transact.being under any compulsion to transact.

Key phrases in this definition:Key phrases in this definition:1.1. Open and unrestricted market (where supply and demand can Open and unrestricted market (where supply and demand can

freely operate freely operate 2.2. Knowledgeable, informed and prudent partiesKnowledgeable, informed and prudent parties3.3. Arm’s lengthArm’s length4.4. Neither party under any compulsion to transact.Neither party under any compulsion to transact.

Valuation IssuesValuation IssuesValuation FrameworkValuation Framework

15-2 FIGURE

Demand Supply

B1

S1

P

P*Q

Valuation IssuesValuation IssuesTypes of AcquirersTypes of Acquirers

Determining fair market value depends on the perspective of the Determining fair market value depends on the perspective of the acquirer. Some acquirers are more likely to be able to realize acquirer. Some acquirers are more likely to be able to realize synergies than others and those with the greatest ability to generate synergies than others and those with the greatest ability to generate synergies are the ones who can justify higher prices.synergies are the ones who can justify higher prices.

Types of acquirers and the impact of their perspective on Types of acquirers and the impact of their perspective on value include:value include:1.1. Passive investors – use estimated cash flows currently presentPassive investors – use estimated cash flows currently present2.2. Strategic investors – use estimated synergies and changes that are Strategic investors – use estimated synergies and changes that are

forecast to arise through integration of operations with their ownforecast to arise through integration of operations with their own3.3. Financials – valued on the basis of reorganized and refinanced Financials – valued on the basis of reorganized and refinanced

operationsoperations4.4. Managers – value the firm based on their own job potential and ability Managers – value the firm based on their own job potential and ability

to motivate staff and reorganize the firm’s operations. MBOs and to motivate staff and reorganize the firm’s operations. MBOs and LBOsLBOs

Market pricing will reflect these different buyers and their Market pricing will reflect these different buyers and their importance at different stages of the business cycle.importance at different stages of the business cycle.

Market Pricing ApproachesMarket Pricing Approaches

Reactive Pricing ApproachesReactive Pricing ApproachesModels reacting to general rules of thumb and the Models reacting to general rules of thumb and the relative pricing compared to other securitiesrelative pricing compared to other securities

1.1. Multiples or relative valuationMultiples or relative valuation2.2. Liquidation or breakup valuesLiquidation or breakup values

Proactive ModelsProactive ModelsA valuation method to determine what a target firm’s A valuation method to determine what a target firm’s value should be based on future values of cash flow value should be based on future values of cash flow and earningsand earnings

1.1. Discounted cash flow (DCF) modelsDiscounted cash flow (DCF) models

Reactive ApproachesReactive ApproachesValuation Using MultiplesValuation Using Multiples

1.1. Find appropriate comparatorsFind appropriate comparators– Individual firm that is highly comparable to the targetIndividual firm that is highly comparable to the target– Industry average if appropriateIndustry average if appropriate

2.2. Adjust/normalize the data (income statement and balance sheet) Adjust/normalize the data (income statement and balance sheet) for differences between target and comparator including:for differences between target and comparator including:– Accounting differencesAccounting differences

• LIFO versus FIFO LIFO versus FIFO • Accelerated versus straight-line depreciationAccelerated versus straight-line depreciation• Age of depreciable assetsAge of depreciable assets• Pension liabilities, etc.Pension liabilities, etc.

– Different capital structuresDifferent capital structures3.3. Calculate a variety of ratios for both the target and the Calculate a variety of ratios for both the target and the

comparator including:comparator including:– Price-earnings ratio (trailing)Price-earnings ratio (trailing)– Value/EBITDAValue/EBITDA– Price/Book ValuePrice/Book Value– Return on EquityReturn on Equity

4.4. Obtain a range of justifiable values based on the ratiosObtain a range of justifiable values based on the ratios

Reactive ApproachesReactive ApproachesLiquidation ValuationLiquidation Valuation

1.1. Estimate the liquidation value of current Estimate the liquidation value of current assetsassets

2.2. Estimate the present value of tangible assetsEstimate the present value of tangible assets

3.3. Subtract the value of the firm’s liability from Subtract the value of the firm’s liability from estimated liquidation value of all the firm’s estimated liquidation value of all the firm’s assets = liquidation value of the firm.assets = liquidation value of the firm.

This approach values the firm based on existing assets and is This approach values the firm based on existing assets and is not forward looking.not forward looking.

The Proactive ApproachThe Proactive ApproachDiscounted Cash Flow ValuationDiscounted Cash Flow Valuation

• The key to using the DCF approach to price a target The key to using the DCF approach to price a target firm is to obtain good forecasts of free cash flowfirm is to obtain good forecasts of free cash flow

• Free cash flows to equity holders represents cash Free cash flows to equity holders represents cash flows left over after all obligations, including interest flows left over after all obligations, including interest payments have been paid.payments have been paid.

• DCF valuation takes the following steps:DCF valuation takes the following steps:1.1. Forecast free cash flowsForecast free cash flows2.2. Obtain a relevant discount rate Obtain a relevant discount rate 3.3. Discount the forecast cash flows and sum to estimate the value Discount the forecast cash flows and sum to estimate the value

of the targetof the target

(See Equation 15 – 2 on the following slide)(See Equation 15 – 2 on the following slide)

Discounted Cash Flow AnalysisDiscounted Cash Flow AnalysisFree Cash Flow to EquityFree Cash Flow to Equity

esexpenditur)securities

(/.),

,(/

capitalnetmarketableand

cashincludingnotcapitalworkingnetinchangesetctaxesdeferred

onamortizatiitemscashnonincomenetequitytoflowcashFree

[ 15-2]

Discounted Cash Flow AnalysisDiscounted Cash Flow AnalysisThe General DCF ModelThe General DCF Model

• Equation 15 – 3 is the generalized version of Equation 15 – 3 is the generalized version of the DCF model showing how forecast free the DCF model showing how forecast free cash flows are discounted to the present and cash flows are discounted to the present and then summed.then summed.

)1()1(

...)1(

)1( 1

22

11

0

tt

t

k

CF

k

CF

k

CF

k

CFV[ 15-3]

Discounted Cash Flow AnalysisDiscounted Cash Flow AnalysisThe Constant Growth DCF ModelThe Constant Growth DCF Model

• Equation 15 – 4 is the DCF model for a target firm Equation 15 – 4 is the DCF model for a target firm where the free cash flows are expected to grow at a where the free cash flows are expected to grow at a constant rate for the foreseeable future.constant rate for the foreseeable future.

• Many target firms are high growth firms and so a Many target firms are high growth firms and so a multi-stage model may be more appropriate.multi-stage model may be more appropriate.

(See Figure 15 -3 on the following slide for the DCF Valuation Framework.)(See Figure 15 -3 on the following slide for the DCF Valuation Framework.)

10 gk

CFV

[ 15-4]

Valuation IssuesValuation IssuesValuation FrameworkValuation Framework

15-3 FIGURE

Time Period Free Cash Flows

Terminal Value

Discount Rate

)1()1(1

0

T

tT

Tt

t

k

V

k

CV

Discounted Cash Flow AnalysisDiscounted Cash Flow AnalysisThe Multiple Stage DCF ModelThe Multiple Stage DCF Model

• The multi-stage DCF model can be amended The multi-stage DCF model can be amended to include numerous stages of growth in the to include numerous stages of growth in the forecast period.forecast period.

• This is exhibited in equation 15 – 5:This is exhibited in equation 15 – 5:

)1(

)1(1

0 TT

T

tt

t

k

V

k

CFV

[ 15-5]

Valuation IssuesValuation IssuesThe Acquisition Decision and Risks that Must be ManagedThe Acquisition Decision and Risks that Must be Managed

Once the value to the acquirer has been determined, Once the value to the acquirer has been determined, the acquisition will only make sense if the target firm the acquisition will only make sense if the target firm can be acquired at a price that is less.can be acquired at a price that is less.

As the acquirer enters the buying/tender process, the As the acquirer enters the buying/tender process, the outcome is not certain:outcome is not certain:

• Competing bidders may appearCompeting bidders may appear• Arbs may buy up outstanding stock and force price concessions Arbs may buy up outstanding stock and force price concessions

and lengthen the acquisition process (increasing the costs of and lengthen the acquisition process (increasing the costs of acquisitions)acquisitions)

• In the end, the forecast synergies might not be realizedIn the end, the forecast synergies might not be realized

The acquirer can attempt to mitigate some of these risk through The acquirer can attempt to mitigate some of these risk through advance tax rulings from CRA, entering a friendly takeover and advance tax rulings from CRA, entering a friendly takeover and through due diligence.through due diligence.

Valuation IssuesValuation IssuesThe Effect of an Acquisition on Earnings per ShareThe Effect of an Acquisition on Earnings per Share

An acquiring firm can increase its EPS if it An acquiring firm can increase its EPS if it acquires a firm that has a P/E ratio lower acquires a firm that has a P/E ratio lower than its own.than its own.

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M&A