Chapter 29

Mergers and Acquisitions

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

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 paying for an acquisition Understand the various defensive tactics that are available

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Chapter Outline
29.1 The Basic Forms of Acquisitions 29.2 Synergy 29.3 Sources of Synergy 29.4 Two Financial Side Effects of Acquisitions 29.5 A Cost to Stockholders from Reduction in Risk 29.6 The NPV of a Merger 29.7 Friendly versus Hostile Takeovers 29.8 Defensive Tactics 29.9 Do Mergers Add Value? 29.10 The Tax Forms of Acquisitions 29.11 Accounting for Acquisitions 29.12 Going Private and Leveraged Buyouts 29.13 Divestitures
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29.1 The Basic Forms of Acquisitions

There are three basic legal procedures that one firm can use to acquire another firm:

Merger or Consolidation Acquisition of Stock Acquisition of Assets

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Merger versus Consolidation

Merger
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

Consolidation

Entirely new firm is created from combination of existing firms

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Acquisitions

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 unfriendly May be delayed if some target shareholders hold out for more money complete absorption requires a merger

Classifications

Horizontal both firms are in the same industry Vertical firms are in different stages of the production process Conglomerate firms are unrelated
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Varieties of Takeovers
Merger
Acquisition Takeovers Proxy Contest Acquisition of Stock Acquisition of Assets

Going Private (LBO)

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29.2 Synergy

Most acquisitions fail to create value for the acquirer. The main reason why they do not lies in failures to integrate two companies after a merger.

Intellectual capital often walks out the door when acquisitions are not handled carefully. Traditionally, acquisitions deliver value when they allow for scale economies or market power, better products and services in the market, or learning from the new firms.
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Synergy

Suppose firm A is contemplating acquiring firm B. The synergy from the acquisition is Synergy = VAB (VA + VB) The synergy of an acquisition can be determined from the standard discounted cash flow model: T
Synergy =

S
t=1

DCFt

(1 + R)t
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29.3 Sources of Synergy

Revenue Enhancement Cost Reduction

Replacement of ineffective managers Economy of scale or scope Net operating losses Unused debt capacity

Tax Gains

Incremental new investment required in working capital and fixed assets

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Calculating Value

Avoiding Mistakes

Do not ignore market values Estimate only Incremental cash flows Use the correct discount rate Do not forget transactions costs

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29.4 Two Financial Side Effects of Acquisitions

Earnings Growth

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 (i.e., an accounting illusion). Shareholders who wish to diversify can accomplish this at much lower cost with one phone call to their broker than can management with a takeover.

Diversification

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29.5 A Cost to Stockholders from Reduction in Risk

The Base Case

If two all-equity firms merge, there is no transfer of synergies to bondholders, but if The value of the levered shareholders call option falls.

Both Firms Have Debt

How Can Shareholders Reduce their Losses from the Coinsurance Effect?

Retire debt pre-merger and/or increase post-merger debt usage.

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29.6 The NPV of a Merger

Typically, a firm would use NPV analysis when making acquisitions. The analysis is straightforward with a cash offer, but it gets complicated when the consideration is stock.

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Cash Acquisition

The NPV of a cash acquisition is:

NPV = (VB + V) cash cost = VB* cash cost

Value of the combined firm is:

VAB = VA + (VB* cash cost)

Often, the entire NPV goes to the target firm. Remember that a zero-NPV investment may also be desirable.

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Stock Acquisition

Value of combined firm

VAB = VA + VB + DV

Cost of acquisition
Depends on the number of shares given to the target stockholders Depends on the price of the combined firms stock after the merger

Considerations when choosing between cash and stock

Sharing gains target stockholders do not participate in stock price appreciation with a cash acquisition Taxes cash acquisitions are generally taxable Control cash acquisitions do not dilute control
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29.7 Friendly vs. Hostile Takeovers

In a friendly merger, both companies management are receptive. In a hostile merger, the acquiring firm attempts to gain control of the target without their approval.

Tender offer Proxy fight

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29.8 Defensive Tactics

Corporate charter
Classified board (i.e., staggered elections) Supermajority voting requirement

Golden parachutes Targeted repurchase (a.k.a. greenmail) Standstill agreements Poison pills (share rights plans) Leveraged buyouts

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More (Colorful) Terms

Poison put Crown jewel White knight Lockup Shark repellent Bear hug Fair price provision Dual class capitalization Countertender offer
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29.9 Do Mergers Add Value?

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.

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Do Mergers Add Value?

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.
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29.10 The Tax Forms of Acquisition

If it is a taxable acquisition, selling shareholders need to figure their cost basis and pay taxes on any capital gains. If it is not a taxable event, shareholders are deemed to have exchanged their old shares for new ones of equivalent value.

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29.11 Accounting for Acquisitions

The Purchase Method

Assets of the acquired firm are reported at their fair market value. Any excess payment above the fair market value is reported as goodwill. Historically, goodwill was amortized. Now it remains on the books until it is deemed impaired.

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29.12 Going Private and Leveraged Buyouts

The existing management buys the firm from the shareholders and takes it private. If it is financed with a lot of debt, it is a leveraged buyout (LBO). The extra debt provides a tax deduction for the new owners, while at the same time turning the pervious managers into owners. This reduces the agency costs of equity.

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29.13 Divestitures
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 stockholders

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Quick Quiz

What are the different methods for achieving a takeover? How do we account for acquisitions? What are some of the reasons cited for mergers? Which of these may be in stockholders best interest and which generally are not? What are some of the defensive tactics that firms use to thwart takeovers? How can a firm restructure itself? How do these methods differ in terms of ownership?
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