FI-561 MERGERS & ACQUISITIONS

WEEK 2 HOMEWORK ANSWER KEY

Case 3.3 AOL Time Warner Case (Chapter 3, pp. 87-88)

C3.31
Price per share paid to TWX = exchange ratio AOL price per share = 1.5 $72.88
= $109.32
Premium to TWX shareholders = ($109.32 $64.75) / $64.75 = $44.57 / $64.75 = 68.8%
= $109.32/$64.75 1 = 1.69 1 = 68.8%
C3.3.2
Value of AOL on 9/10/02 = share price number of shares = $13.36 4.45 billion
= $59.5 billion
Dollar Decline = $342.6 billion $59.5 billion = $283.1 billion
Percent Decline = $283.1 billion / $342.6 billion = 82.6%
C3.3.3
AOL paid $153.1 billion in stock value for TWX. So this is the total adjustment to be accounted
for. The basic entries for purchase accounting are:
Eliminate TWX book equity by a debit of $10 billion. Next, miscellaneous adjustments reflected
in a debit of $30.9 billion were made. The total increase in goodwill is $174 billion. So the sum
of the pro forma debit adjustments equals the market value of AOL stock paid for TWX.
We next consider the credits. The AOL common stock at par issued to pay for the purchase of
TWX is a credit of $0.1 billion (rounded). This is deducted from the amount paid for TWX to
obtain $153.0 billion which becomes the addition to AOL paid in capital.
C3.3.4
Asset Structure Changes in AOL and TWX ($ millions)
Pro Forma
Post Merger

Pre Merger
AOL
Amount
Total Assets
Goodwill+other intangibles
Tangible assets

$10,789

TWX
%

Amount

Combined
%

Amount

100.0%

$50,213

100.0%

$235,388

100.0%

$432

4.0%

$24,507

48.8%

$199,325

84.7%

$10,357

96.0%

$25,706

51.2%

$36,063

15.3%

The total assets of AOL pre-merger were about $11 billion. Total assets of TWX were $50
billion. Their sum is $61 billion. But as a result of purchase accounting total assets became
$235 billion much greater than the $61 billion. The reason is the great increase in goodwill
plus other intangibles. Tangible assets were $10 billion plus $26 billion to total $36 billion.

C.3.3.5
Leverage Changes in the AOL and TWX Merger
Pro Forma
Post Merger

Pre Merger
AOL
Total Liabilities
Shareholders' Equity
Total Claims
Liabilities/Equity

Amount
$4,370
$6,419
$10,789

%
40.5%
59.5%
100.0%

TWX
Amount
%
$39,949
79.6%
$10,264
20.4%
$50,213
100.0%

Combined
Amount
%
$79,095
33.6%
$156,293
66.4%
$235,388
100.0%

68.1%

389.2%

50.6%

Leverage changes reduced the combined firms liabilities-to-shareholders equity to 50.6%. This
reflected the large increase in paid in capital because of the large premium paid by AOL to TWX.
On 3/21/02, AOL-TWX had a market value of equity of $110 billion, 29.5% below the book
equity of $156 billion; liabilities-to-market equity were $79 billion/$110 billion equals 72%.
On 3/26/02, AOL announced a $54 billion write down to reflect the impairment of goodwill.
FASBs Statement of Financial Standards No. 142 on Goodwill and Other Intangible Assets
issued June 2001 states in 43 p. 16: The aggregate amount of goodwill impairment losses shall
be presented as a separate line in the income statement before the subtotal income from
continuing operations (or similar caption)

Question 4.2 (Chapter 4, p. 99)

Stock-for-stock transactions: Generally a nontaxable transaction. Acquired firm shareholders
deferred gains; still retain ownership in combined firm. Acquiring firm shareholders no
cash outlay or borrowing required; carryover of NOLs, tax credits, asset basis.
Cash-for-stock transactions: Acquired firm shareholders immediate gain recognition; no
longer have ownership interest. Acquiring firm shareholders potential benefits of stepped-up
asset basis for future depreciation.

Questions 5.1, 5.2, 5.3, 5.4 - (Chapter 5, p.123)

5.1
Strategy represents a long-range approach to dealing with the most fundamental aspects of a
firm's performance, present and future, in relation to its changing environment. Strategic
planning provides an approach to dealing with large-scale uncertainty and ill-structured
problems. Although it is mainly concerned with long-term issues, it must also consider the
effects of short-term and mid-term decisions and actions on the long-run goals and performance
of the firm.

5.2
Porter identifies attractive industries as those with the following characteristics:
a. High entry barriers.
b. Suppliers and/or buyers have weak bargaining power.
c. Few available substitute products/services.
d. Stable rivalry among competitors.
5.3
Cost leadership versus product differentiation.
a. Competitive advantage through cost leadership is based on a wide-ranging checklist which
includes the Boston Consulting Group Experience Curve theory.
b. Competitive advantage through product differentiation relates to formulating a strategy based
on product qualities not easily imitated by other firms.
5.4
a. Possible entry barriers:
1. Lower costs due to greater efficiencies.
2. Lower costs due to economies of scale.
3. Lower costs due to position on learning curve.
4. Advertising advantages.
5. Product differentiation advantages.
6. Large capital requirements for minimum required investment.
b. Significance. If they exist, they would confer market power to the holder; the ability to
restrict output and raise prices without the competition of supply increases by other firms. As
a result, firms within the industry need only concern themselves with a finite group of rivals
and have a greater ability to achieve above normal rates of return. But it is difficult to
separate entry barriers from superior efficiency of incumbent firms.