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Chapter Thirty

Finance
Mergers andCorporate
Acquisitions
Ross Westerfield Jaffe

30

Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Chapter Outline
30.1 The Basic Forms of Acquisitions
30.2 The Tax Forms of Acquisitions
30.3 Accounting for Acquisitions
30.4 Determining the Synergy from an Acquisition
30.5 Source of Synergy from Acquisitions
30.6 Calculating the Value of the Firm after an Acquisition
30.7 A Cost to Stockholders from Reduction in Risk
30.8 Two "Bad" Reasons for Mergers
30.9 The NPV of a Merger
30.10 Defensive Tactics
30.11 Some Evidence on Acquisitions
30.12 Summary and Conclusions
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30.1 The Basic Forms of Acquisitions

There are three basic legal procedures that one firm
can use to acquire another firm:
Merger
Acquisition of Stock
Acquisition of Assets

Although these forms are different from a legal

standpoint, the financial press frequently does not
distinguish among them.
In our discussions, we use the term merger
regardless of the actual form of the acquisition.
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Merger or Consolidation
A merger refers to the absorption of one firm by another. The
acquiring firm retains its name and identity, and acquires all
the assets and liabilities of the acquired firm. After the
merger, the acquired firm ceases to exist as a separate entity.
A consolidation is 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.
An advantage of using a merger to acquire a firm is that it is
legally straightforward and does not cost as much as other
forms of acquisition.
A disadvantage is that a merger must be approved by a vote
of the shareholders of each firm.
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Acquisition of Stock
A firm can acquire another firm by purchasing
target firms voting stock in exchange for cash,
shares of stock, or other securities.
A tender offer is a public offer to buy shares made
by one firm directly to the shareholders of another
firm.
If the shareholders choose to accept the offer, they tender
their shares by exchanging them for cash or securities.
A tender offer is frequently contingent on the bidders
obtaining some percentage of the total voting shares.
If not enough shares are tendered, then the offer might be
withdrawn or reformulated.
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Acquisition of Assets
One firm can acquire another by buying all of its
assets.
A formal vote of the shareholders of the selling firm
is required.
Advantage of this approach: it avoids the potential
problem of having minority shareholders that may
occur in an acquisition of stock.
Disadvantage of this approach: it involves a costly
legal process of transferring title.

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A Classification Scheme
Financial analysts typically classify acquisitions
into three types:
Horizontal acquisition: when the acquirer and the target
are in the same industry.
Vertical acquisition: when the acquirer and the target are
at different stages of the production process; example: an
airline company acquiring a travel agency.
Conglomerate acquisition: the acquirer and the target are
not related to each other.

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A Note on Takeovers
Takeover is a general and imprecise term referring
to the transfer of control of a firm from one group of
shareholders to another.
Takeover can occur by acquisition, proxy contests,
and going-private transactions.
In a proxy contest, a group of shareholders attempts
to gain controlling seats on the board of directors by
voting in new directors.
A proxy authorizes the proxy holder to vote on all
matters in a shareholders meeting.
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Varieties of Takeovers
Merger

Takeovers

Acquisition

Acquisition of Stock

Proxy Contest

Acquisition of Assets

Going Private
(LBO)

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30.2 The Tax Forms of Acquisitions

In a taxable acquisition, the shareholders of the
target firm are considered to have sold their shares,
and they will have capital gain/losses that will be
taxed.
In a tax-free acquisition, since the acquisition is
considered an exchange instead of a sale, no capital
gain or loss occurs.

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30.3 Accounting for Acquisitions

The Purchase Method
The source of much goodwill

Pooling of Interests
Pooling of interest is generally used when the
acquiring firm issues voting stock in exchange for at
least 90-percent of the outstanding voting stock of
the acquired firm.
Purchase accounting is generally used under other
financing arrangements.

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30.4 Determining the Synergy from an

Acquisition
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 aren't 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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30.5 Source of Synergy from Acquisitions

Revenue Enhancement
Cost Reduction
Including replacing ineffective managers.

Tax Gains
Net Operating Losses
Unused Debt Capacity

The Cost of Capital

Economies of Scale in Underwriting.

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30.6 Calculating the Value of the Firm

after an Acquisition
Avoiding Mistakes

Do not Ignore Market Values

Estimate only Incremental Cash Flows
Use the Correct Discount Rate
Dont Forget Transactions Costs

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30.7 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

One Firm has Debt

The value of the levered shareholders call option falls.

How Can Shareholders Reduce their Losses from

the Coinsurance Effect?
Retire debt pre-merger.

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30.8 Two "Bad" Reasons for Mergers

Earnings Growth
Only an accounting illusion.

Diversification
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.

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30.9 The NPV of a Merger

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

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The NPV of a Merger: Cash

NPV of merger to acquirer =

Synergy Premium

Synergy VAB (VA VB )

Premium = Price paid for B - VB

NPV of merger to acquirer = Synergy - Premium
VAB (VA VB ) [Price paid for B VB ]
VAB VA VB Price paid for B VB
VAB VA Price paid for B
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The NPV of a Merger: Common Stock

The analysis gets muddied up because we need to
consider the post-merger value of those shares
were giving away.

Target firm payout New firm value

New shares issued

Old shares New shares issued

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Cash versus Common Stock

Overvaluation
If the target firm shares are too pricey to buy with cash,
then go with stock.

Taxes
Cash acquisitions usually trigger taxes.
Stock acquisitions are usually tax-free.

Sharing Gains from the Merger

With a cash transaction, the target firm shareholders are
not entitled to any downstream synergies.

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30.10 Defensive Tactics

Target-firm managers frequently resist takeover
attempts.
It can start with press releases and mailings to
shareholders that present managements viewpoint
and escalate to legal action.
Management resistance may represent the pursuit of
self interest at the expense of shareholders.
Resistance may benefit shareholders in the end if it
results in a higher offer premium from the bidding
firm or another bidder.
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Divestitures
The basic idea is to reduce the potential
diversification discount associated with commingled
operations and to increase corporate focus.
Divestiture can take three forms:
Sale of assets: usually for cash
Spinoff: parent company distributes shares of a subsidiary
to shareholders. Shareholders wind up owning shares in two
firms. Sometimes this is done with a public IPO.
Issuance if tracking stock: a class of common stock whose
value is connected to the performance of a particular
segment of the parent company.

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The Control Block and The Corporate Charter

If one individual or group owns 51-percent of a companys
stock, this control block makes a hostile takeover virtually
impossible.
Control blocks are typical in Canada, although they are the
exception in the United States.
The corporate charter establishes the conditions that allow a
takeover.
Target firms frequently amend corporate charters to make
acquisitions more difficult.
Examples
Staggering the terms of the board of directors.
Requiring a supermajority shareholder approval of an acquisition
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Repurchase Standstill Agreements

In a targeted repurchase the firm buys back its own
stock from a potential acquirer, often at a premium.
Critics of such payments label them greenmail.
Standstill agreements are contracts where the
bidding firm agrees to limit its holdings of another
firm.
These usually leads to cessation of takeover attempts.
When the market decides that the target is out of play, the
stock price falls.

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Exclusionary Offers and Nonvoting Stock

The opposite of a targeted repurchase.
The target firm makes a tender offer for its own
stock while excluding targeted shareholders.
An example:
In 1986, the Canadian Tire Dealers Association offered to
buy 49% of the companys voting shares from the
founding Billes family.
The offer was voided by the OSC, since it was viewed as
an illegal form of discrimination against one group of
shareholders.

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Going Private and LBOs

If 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 previous
managers into owners.
This reduces the agency costs of equity

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Other Defensive Devices

Golden parachutes are compensation to outgoing
target firm management.
Crown jewels are the major assets of the target. If
the target firm management is desperate enough,
they will sell off the crown jewels.
White Knight is a friendly bidder who promises to
maintain the jobs of existing management.
Poison pills are measures of true desperation to
make the firm unattractive to bidders. They reduce
shareholder wealth.
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30.11 Some Evidence on Acquisitions: Stock Price

Changes in Successful U.S. Corporate Takeovers

Takeover
Technique
Tender offer
Merger
Proxy contest

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Successful
Targets Bidder
30%
20%
8%

4%
0%
NA

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Abnormal Returns in Successful Canadian

Mergers

Mergers 1964--83
Going private
Transactions 1977--89
- Minority buyouts
- Non-controlling bidder

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Target
9%

Bidder
3%

25%
27%
24%

NA
NA
NA

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Comparison of U.S. vs. Canadian

Mergers
The evidence both in U.S. and Canada strongly
suggests that shareholders of successful target firms
achieve substantial gains from takeovers.
Shareholders of bidding firms earn significantly less
from takeovers. The balance is more even for
Canadian mergers than for U.S. ones.
The reasons may be:
There is less competition among bidders in Canada.
The Canadian capital market is smaller.
There are federal government agencies to review foreign
investments.
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30.12 Summary and Conclusions

The three legal forms of acquisition are

1. Merger and consolidation
2. Acquisition of stock
3. Acquisition of assets

M&A requires an understanding of complicated

tax and accounting rules.
The synergy from a merger is the value of the
combined firm less the value of the two firms as
separate entities.
Synergy VAB (VA VB )

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30.12 Summary and Conclusions

The possible synergies of an acquisition come

from the following:

Revenue enhancement
Cost reduction
Lower taxes
Lower cost of capital

The reduction in risk may actually help existing

bondholders at the expense of shareholders.

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