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Corporate Finance Ross Westerfield Jaffe Sixth Edition

30Chapter Thirty

Mergers and Acquisitions

Prepared by

Gady JacobyUniversity of Manitoba

and

Sebouh AintablianAmerican University of Beirut

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Chapter Outline

30.1 The Basic Forms of Acquisitions30.2 The Tax Forms of Acquisitions30.3 Accounting for Acquisitions30.4 Determining the Synergy from an Acquisition30.5 Source of Synergy from Acquisitions30.6 Calculating the Value of the Firm after an Acquisition30.7 A Cost to Stockholders from Reduction in Risk30.8 Two "Bad" Reasons for Mergers30.9 The NPV of a Merger30.10 Defensive Tactics30.11 Some Evidence on Acquisitions30.12 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 firm’s 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 bidder’s

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

Takeovers

Acquisition

Proxy Contest

Going Private(LBO)

Merger

Acquisition of Stock

Acquisition of Assets

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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

– Don’t 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 shareholder’s 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 BAAB VVV

Premium = Price paid for B - VB

NPV of merger to acquirer = Synergy - Premium

]for paid Price[)( BBAAB VBVVV

BBAAB VBVVV for paid Price

BVV AAB for paid Price

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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 we’re giving away.

valuefirm Newpayout firmTarget

issued shares Newshares Old

issued shares New

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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 management’s 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 company’s 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 company’s 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 Successful

Technique Targets Bidder

Tender offer 30% 4%

Merger 20% 0%

Proxy contest 8% NA

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Abnormal Returns in Successful Canadian Mergers

Target Bidder

Mergers 1964--83 9% 3%

Going private

Transactions 1977--89 25% NA

- Minority buyouts 27% NA

- Non-controlling bidder 24% 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 are1. 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 BAAB VVV

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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.