Chapter 15 mergers and acquisitions

Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

Chapter 15 – Mergers and AcquisitionsChapter 15 – Mergers and Acquisitions

CHAPTER 15CHAPTER 15 Mergers and AcquisitionsMergers and Acquisitions

CHAPTER 15 – Mergers and Acquisitions 15 - 3

Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Types of TakeoversTypes of Takeovers• Securities LegislationSecurities Legislation• Friendly versus hostile takeoversFriendly versus hostile takeovers• Motivations for Mergers and AcquisitionsMotivations for Mergers and Acquisitions• Valuation IssuesValuation Issues• Accounting for AcquisitionsAccounting for Acquisitions• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions


Learning ObjectivesLearning Objectives

1.1. The different types of acquisitionsThe different types of acquisitions

2.2. How a typical acquisition proceedsHow a typical acquisition proceeds

3.3. What differentiates a friendly from a hostile What differentiates a friendly from a hostile acquisitionacquisition

4.4. Different forms of combinations of firmsDifferent forms of combinations of firms

5.5. Where to look for acquisition gainsWhere to look for acquisition gains

6.6. How accounting may affect the acquisition How accounting may affect the acquisition decisiondecision


Important Chapter TermsImportant Chapter Terms

• AcquisitionAcquisition• AmalgamationAmalgamation• ArbsArbs• Asset purchaseAsset purchase• Break feeBreak fee• Cash transactionCash transaction• Confidentiality agreementConfidentiality agreement• Conglomerate mergerConglomerate merger• Creeping takeoversCreeping takeovers• Cross-border Cross-border

(international) M&A(international) M&A• Data roomData room• Defensive tacticDefensive tactic• Due diligenceDue diligence

• Extension M&AExtension M&A• Fair market valueFair market value• Fairness opinionFairness opinion• Friendly acquisitionFriendly acquisition• Geographic roll-upGeographic roll-up• Going private Going private

transaction/issuer bidtransaction/issuer bid• GoodwillGoodwill• Horizontal mergerHorizontal merger• Hostile takeoverHostile takeover• Letter of intentLetter of intent• Management buyouts Management buyouts

(MBOs)/leveraged buyouts (MBOs)/leveraged buyouts (LBOs)(LBOs)

• MergerMerger


Important Chapter Terms…Important Chapter Terms…

• No-shop clauseNo-shop clause• Offering memorandumOffering memorandum• Over-capacity M&AOver-capacity M&A• Proactive modelsProactive models• Purchase methodPurchase method• Selling the crown jewelsSelling the crown jewels• Share transactionShare transaction• Shareholders rights Shareholders rights

plan/poison pillplan/poison pill• SynergySynergy• TakeoverTakeover

• TenderTender• Tender offerTender offer• Vertical mergerVertical merger• White knightWhite knight

Types of TakeoversTypes of Takeovers

Mergers and AcquisitionsMergers 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


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.

Securities Laws Pertaining to Securities Laws Pertaining to TakeoversTakeovers



General Intent of the LegislationGeneral Intent of the Legislation

Transparency – Information DisclosureTransparency – Information Disclosure• To ensure complete and timely information be To ensure complete and timely information be

available to all parties (especially minority available to all parties (especially minority shareholders) throughout the process while at the shareholders) throughout the process while at the same time not letting this requirement stall the same time not letting this requirement stall the process unduly.process unduly.

Fair TreatmentFair Treatment• To avoid oppression or coercion of minority To avoid oppression or coercion of minority

shareholders.shareholders.• To permit competing bids during the process and not To permit competing bids during the process and not

have the first bidder have special rights. (In this way, have the first bidder have special rights. (In this way, shareholders have the opportunity to get the greatest shareholders have the opportunity to get the greatest and fairest price for their shares.)and fairest price for their shares.)

• To limit the ability of a minority to frustrate the will of To limit the ability of a minority to frustrate the will of a majority. (minority squeeze out provisions)a majority. (minority squeeze out provisions)


Exempt TakeoversExempt Takeovers

• Private companies are generally exempt from Private companies are generally exempt from provincial securities legislation.provincial securities legislation.

• Public companies that have few shareholders Public companies that have few shareholders in one province may be subject to takeover in one province may be subject to takeover laws of another province where the majority laws of another province where the majority of shareholders reside. of shareholders reside.


Exemption from Takeover Requirements Exemption from Takeover Requirements for Control Blocksfor Control Blocks

• Purchase of securities from 5 or fewer Purchase of securities from 5 or fewer shareholders are permitted without a tender shareholders are permitted without a tender offer requirement provided the premium over offer requirement provided the premium over the market price is less than 15%the market price is less than 15%


Creeping TakeoversCreeping TakeoversThe 5% RuleThe 5% Rule

The 5% ruleThe 5% rule• Normal course tender offer is not required as Normal course tender offer is not required as

long as no more than 5% of the outstanding long as no more than 5% of the outstanding shares are purchased through the exchange shares are purchased through the exchange over a one-year period of time.over a one-year period of time.

• This allows creeping takeovers where the This allows creeping takeovers where the company acquires the target over a long company acquires the target over a long period of time.period of time.


Securities LegislationSecurities LegislationCritical Shareholder PercentagesCritical Shareholder Percentages

1.1. 10%: Early Warning10%: Early Warning• When a shareholder hits this point a report is sent to OSC When a shareholder hits this point a report is sent to OSC • This requirement alters other shareholders that a potential This requirement alters other shareholders that a potential

acquisitor is accumulating a position (toehold) in the firm.acquisitor is accumulating a position (toehold) in the firm.

2.2. 20%: Takeover Bid20%: Takeover Bid• Not allowed further open market purchases but must make Not allowed further open market purchases but must make

a takeover bida takeover bid• This allows all shareholders an equal opportunity to tender This allows all shareholders an equal opportunity to tender

shares and forces equal treatment of all at the same price.shares and forces equal treatment of all at the same price.• This requirement also forces the acquisitor into disclosing This requirement also forces the acquisitor into disclosing

intentions publicly before moving to full voting control of the intentions publicly before moving to full voting control of the firm.firm.


Securities LegislationSecurities LegislationCritical Shareholder Percentages Continued …Critical Shareholder Percentages Continued …

3.3. 50.1%: Control50.1%: Control• Shareholder controls voting decisions under normal voting Shareholder controls voting decisions under normal voting

(simple majority)(simple majority)• Can replace board and control managementCan replace board and control management

4.4. 66.7%: Amalgamation66.7%: Amalgamation• The single shareholder can approve amalgamation The single shareholder can approve amalgamation

proposals requiring a 2/3s majority vote (supermajority)proposals requiring a 2/3s majority vote (supermajority)

5.5. 90%: Minority Squeeze-out90%: Minority Squeeze-out• Once the shareholder owns 90% or more of the outstanding Once the shareholder owns 90% or more of the outstanding

stock minority shareholders can be forced to tender their stock minority shareholders can be forced to tender their shares.shares.

• This provision prevents minority shareholders from This provision prevents minority shareholders from frustrating the will of the majority.frustrating the will of the majority.


The Takeover Bid ProcessThe Takeover Bid ProcessMoving Beyond the 20% ThresholdMoving Beyond the 20% Threshold

• Takeover circular sent to all shareholders.Takeover circular sent to all shareholders.• Target has 15 days to circulate letter to shareholders Target has 15 days to circulate letter to shareholders

with the recommendation of the board of directors to with the recommendation of the board of directors to accept/reject.accept/reject.

• Bid must be open for 35 days following public Bid must be open for 35 days following public announcement.announcement.

• Shareholders tender to the offer by signing Shareholders tender to the offer by signing authorizations.authorizations.

• A Competing bid automatically increases the takeover A Competing bid automatically increases the takeover window by 10 days and shareholders during this time window by 10 days and shareholders during this time can with drawn authorization and accept the can with drawn authorization and accept the competing offer.competing offer.


The Takeover Bid ProcessThe Takeover Bid ProcessProrated Settlement and PriceProrated Settlement and Price

• Takeover bid does not have to be for 100 % Takeover bid does not have to be for 100 % of the shares.of the shares.

• Tender offer price cannot be for less than the Tender offer price cannot be for less than the average price that the acquirer bought shares average price that the acquirer bought shares in the previous 90 days. (prohibits coercive in the previous 90 days. (prohibits coercive bids)bids)

• If more shares are tendered than required If more shares are tendered than required under the tender, everyone who tendered under the tender, everyone who tendered shares will get a prorated number purchased.shares will get a prorated number purchased.


Friendly AcquisitionFriendly Acquisition

The acquisition of a target company that is willing to The acquisition of a target company that is willing to be taken over.be taken over.

Usually, the target will accommodate overtures and Usually, the target will accommodate overtures and provide access to confidential information to facilitate provide access to confidential information to facilitate the scoping and due diligence processes.the scoping and due diligence processes.


Friendly AcquisitionsFriendly AcquisitionsThe Friendly Takeover ProcessThe Friendly Takeover Process

1.1. Normally starts when the target voluntarily puts itself into play.Normally starts when the target voluntarily puts itself into play.• Target uses an investment bank to prepare an Target uses an investment bank to prepare an offering offering

memorandummemorandum– May set up a data room and use confidentiality agreements to permit May set up a data room and use confidentiality agreements to permit

access to interest parties practicing due diligenceaccess to interest parties practicing due diligence– A signed letter of intent signals the willingness of the parties to move A signed letter of intent signals the willingness of the parties to move

to the next step – (usually includes a no-shop clause and a to the next step – (usually includes a no-shop clause and a termination or break fee)termination or break fee)

– Legal team checks documents, accounting team may seek advance Legal team checks documents, accounting team may seek advance tax ruling from CRAtax ruling from CRA

– Final sale may require negotiations over the structure of the deal Final sale may require negotiations over the structure of the deal including:including:

» Tax planningTax planning» Legal structuresLegal structures

2.2. Can be initiated by a friendly overture by an acquisitor seeking Can be initiated by a friendly overture by an acquisitor seeking information that will assist in the valuation process.information that will assist in the valuation process.

(See Figure 15 -1 for a Friendly Acquisition timeline)(See Figure 15 -1 for a Friendly Acquisition timeline)


Friendly AcquisitionFriendly Acquisition

15-1 FIGURE

Friendly Acquisition

Information memorandum

Approachtarget

Sign letterof intent

Final saleagreement

Confidentialityagreement

Main duediligence

Ratified


Friendly TakeoversFriendly TakeoversStructuring the AcquisitionStructuring the Acquisition

In friendly takeovers, both parties have the In friendly takeovers, both parties have the opportunity to structure the deal to their mutual opportunity to structure the deal to their mutual satisfaction including:satisfaction including:

1.1. Taxation Issues – cash for share purchases trigger capital gains Taxation Issues – cash for share purchases trigger capital gains so share exchanges may be a viable alternativeso share exchanges may be a viable alternative

2.2. Asset purchases rather share purchases that may:Asset purchases rather share purchases that may:• Give the target firm cash to retire debt and restructure financingGive the target firm cash to retire debt and restructure financing• Acquiring firm will have a new asset base to maximize CCA Acquiring firm will have a new asset base to maximize CCA

deductionsdeductions• Permit escape from some contingent liabilities (usually excluding Permit escape from some contingent liabilities (usually excluding

claims resulting from environmental lawsuits and control orders that claims resulting from environmental lawsuits and control orders that cannot severed from the assets involved)cannot severed from the assets involved)

3.3. Earn outsEarn outs where there is an agreement for an initial purchase price where there is an agreement for an initial purchase price with conditional later payments depending on the performance of with conditional later payments depending on the performance of the target after acquisition.the target after acquisition.


Hostile TakeoversHostile Takeovers

A takeover in which the target has no desire to be A takeover in which the target has no desire to be acquired and actively rebuffs the acquirer and acquired and actively rebuffs the acquirer and refuses to provide any confidential information.refuses to provide any confidential information.

The acquirer usually has already accumulated an The acquirer usually has already accumulated an interest in the target (20% of the outstanding shares) interest in the target (20% of the outstanding shares) and this preemptive investment indicates the and this preemptive investment indicates the strength of resolve of the acquirer.strength of resolve of the acquirer.


Hostile TakeoversHostile TakeoversThe Typical ProcessThe Typical Process

The typical hostile takeover process:The typical hostile takeover process:1.1. Slowly acquire a toehold (beach head) by open market purchase of Slowly acquire a toehold (beach head) by open market purchase of

shares at market prices without attracting attention.shares at market prices without attracting attention.2.2. File statement with OSC at the 10% early warning stage while not File statement with OSC at the 10% early warning stage while not

trying to attract too much attention.trying to attract too much attention.3.3. Accumulate 20% of the outstanding shares through open market Accumulate 20% of the outstanding shares through open market

purchase over a longer period of timepurchase over a longer period of time4.4. Make a tender offer to bring ownership percentage to the desired level Make a tender offer to bring ownership percentage to the desired level

(either the control (50.1%) or amalgamation level (67%)) - this offer (either the control (50.1%) or amalgamation level (67%)) - this offer contains a provision that it will be made only if a certain minimum contains a provision that it will be made only if a certain minimum percentage is obtained.percentage is obtained.

During this process the acquirer will try to monitor During this process the acquirer will try to monitor management/board reaction and fight attempts by them management/board reaction and fight attempts by them to put into effect shareholder rights plans or to launch to put into effect shareholder rights plans or to launch other defensive tactics.other defensive tactics.


Hostile TakeoversHostile TakeoversCapital Market Reactions and Other DynamicsCapital Market Reactions and Other Dynamics

Market clues to the potential outcome of a hostile takeover Market clues to the potential outcome of a hostile takeover attempt:attempt:

1.1. Market price jumps above the offer priceMarket price jumps above the offer price• A competing offer is likely orA competing offer is likely or• The bid price is too lowThe bid price is too low

2.2. Market price stays close to the offer priceMarket price stays close to the offer price• The offer price is fair and the deal will likely go throughThe offer price is fair and the deal will likely go through

3.3. Little trading in the sharesLittle trading in the shares• A bad sign for the acquirer because shareholders are reluctant to sell.A bad sign for the acquirer because shareholders are reluctant to sell.

4.4. Great deal of trading in the sharesGreat deal of trading in the shares• Large numbers of shares being sold from normal investors to arbitrageurs Large numbers of shares being sold from normal investors to arbitrageurs

(arbs) who are, themselves building a position to negotiate an even bigger (arbs) who are, themselves building a position to negotiate an even bigger premium for themselves by coordinating a response to the tender offer.premium for themselves by coordinating a response to the tender offer.


Hostile TakeoversHostile TakeoversDefensive TacticsDefensive Tactics

Shareholders Rights PlanShareholders Rights Plan• Known as a poison pill or deal killerKnown as a poison pill or deal killer• Can take different forms but oftenCan take different forms but often

Gives non-acquiring shareholders get the right to buy 50 percent more Gives non-acquiring shareholders get the right to buy 50 percent more shares at a discount price in the event of a takeover.shares at a discount price in the event of a takeover.

Selling the Crown JewelsSelling the Crown Jewels• The selling of a target company’s key assets that the acquiring The selling of a target company’s key assets that the acquiring

company is most interested in to make it less attractive for takeover.company is most interested in to make it less attractive for takeover.• Can involve a large dividend to remove excess cash from the target’s Can involve a large dividend to remove excess cash from the target’s

balance sheet.balance sheet.

White KnightWhite Knight• The target seeks out another acquirer considered friendly to make a The target seeks out another acquirer considered friendly to make a

counter offer and thereby rescue the target from a hostile takeovercounter offer and thereby rescue the target from a hostile takeover

Motives for TakeoversMotives for Takeovers



Classifications Mergers and AcquisitionsClassifications Mergers and Acquisitions

1.1. HorizontalHorizontal• 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 Often in an attempt to achieve economies of scale and/or

scope.scope.2.2. VerticalVertical

• A merger in which one firm acquires a supplier or another firm A merger in which one firm acquires a supplier or another firm that is closer to its existing customers.that is 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.3.3. ConglomerateConglomerate

• 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 Purpose is often to ‘diversify’ the company by combining

uncorrelated assets and income streamsuncorrelated assets and income streams4.4. Cross-border (International) M&AsCross-border (International) M&As

• A merger or acquisition involving a Canadian and a foreign firm A merger or acquisition involving a Canadian and a foreign firm a either the acquiring or target company.a either the acquiring or target company.


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

• Table 15 -1 on the following slide depicts Table 15 -1 on the following slide depicts major M&A waves since the late 1800s.major M&A waves since the late 1800s.


M&A Activity in CanadaM&A Activity in CanadaPeriod Major Characteristics of M&A Activity1895 - 1904 • Driven by economic expansion, U.S. transcontinental railroad, and the development of

national U.S. capital markets

• Characterized by horizontal M&As1922 - 1929 • 60 percent occurred in fragmented markets (chemical, food processing, mining)

• Driven by growth in transportation and merchandising, as well as by communications developments

1940 - 1947 • Characterized by vertical integration• Driven by evasion of price and quota controls

1960s • Characterized by conglomerate M&As• Driven by aerospace industry• Some firms merged to play the earnings per share "growth game" (discussed in the section

The Effect of an Acquisition on Earnings per Share)1980s • Characterized by leveraged buyouts and hostile takeovers1990s • Many international M&As (e.g., Chrysler and Daimler-Benz, Seagram and Martell)

• Strategic motives were advanced (although the jury is still out on whether this was truly achieved)

1999 - 2001 • High technology/Internet M&As• Many stock-financed takeovers, fuelled by inflated stock prices• Many were unsuccessful and/or fell through as the Internet "bubble" burst

2005 - ? • Resource-based/international M&A activity• Fuelled by strong industry fundamentals, low financing costs, strong economic conditions

Table 15 - 1 M&A Activity in Canada

Source: Adapted in part f rom Weston, J.F., Wang, F., Chung, S., and Hoag, S. Mergers, Restructuring, and Corporate Control. Toronto:

Prentice-Hall Canada, Inc., 1990.


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 firmthe 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 issuing costsReduction in average issuing 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)

• New firm will have operating income to make full use of available New firm will have operating income to make full use of available CCA.CCA.

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 Empirical Evidence of Gains through M&AsM&As

• Target shareholders gain the mostTarget shareholders gain the most– Through premiums paid to them to acquire their sharesThrough premiums paid to them to acquire their shares

• 15 – 20% for stock-finance acquisitions15 – 20% for stock-finance acquisitions

• 25 – 30% for cash-financed acquisitions (triggering capital gains 25 – 30% for cash-financed acquisitions (triggering capital gains taxes for these shareholders)taxes for these shareholders)

– Gains may be greater for shareholders will to wait for ‘arbs’ to Gains may be greater for shareholders will to wait for ‘arbs’ to negotiate higher offers or bidding wars develop between negotiate higher offers or bidding wars develop between multiple acquirers.multiple acquirers.

• Between 1995 and 2001, 302 deals worth US$500.Between 1995 and 2001, 302 deals worth US$500.– 61% lost value over the following year 61% lost value over the following year – The biggest losers were deals financed through shares which The biggest losers were deals financed through shares which

lost an average 8%.lost an average 8%.


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 – see Figure 15 -2 on the following slide)freely operate – see Figure 15 -2 on the following slide)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.

Accounting Implications of TakeoversAccounting Implications of Takeovers



Accounting for Acquisitions Accounting for Acquisitions

Historically firms could use one of two Historically firms could use one of two approaches to account for business approaches to account for business combinationscombinations

1.1. Purchase method andPurchase method and2.2. Pooling-of-interest method (no longer allowed)Pooling-of-interest method (no longer allowed)

While more popular in other countries, the pooling of While more popular in other countries, the pooling of interest is no longer allowed by:interest is no longer allowed by:• CICA in CanadaCICA in Canada• Financial Accounting Standards Board (FASB) in the U.S. Financial Accounting Standards Board (FASB) in the U.S.

andand• Internal Accounting Standards Board (IASB)Internal Accounting Standards Board (IASB)


Accounting for Acquisitions Accounting for Acquisitions The Purchase MethodThe Purchase Method

One firm assumes all assets and liabilities and One firm assumes all assets and liabilities and operating results going forward of the target firm.operating results going forward of the target firm.

How is this done?How is this done?• All assets and liabilities are expressed at their fair market All assets and liabilities are expressed at their fair market

value (FMV) as of the acquisition date.value (FMV) as of the acquisition date.• If the FMV > the target firm’s equity, the excess amount is If the FMV > the target firm’s equity, the excess amount is

goodwill and reported as an intangible asset on the left goodwill and reported as an intangible asset on the left hand side of the balance sheet.hand side of the balance sheet.

• Goodwill is no longer amortized but must be annually Goodwill is no longer amortized but must be annually assessed to determine if has been permanently ‘impaired’ assessed to determine if has been permanently ‘impaired’ in which case, the value will be written down and charged in which case, the value will be written down and charged against earnings per share.against earnings per share.


Example of the Purchase Method Example of the Purchase Method Accounting for AcquisitionsAccounting for Acquisitions

Acquisitor purchases Target firm for $1,250 in cash on June 30, Acquisitor purchases Target firm for $1,250 in cash on June 30, 2006.2006.

Acquisitor Pre- Merger

Target Firm (Book Value)

Target Firm (Fair Market

Value)

Current assets 10,000 1,200 1,300Long-term assets 6,000 800 900GoodwillTotal Assets 16,000 2,000 2,200

Current liabilities 8,000 800 800Long-term debt 2,000 200 250Common stock 2,000 400 1,250Retained earnings 4,000 600Total Claims 16,000 2,000 2,300


Example of the Purchase Method Example of the Purchase Method Accounting for AcquisitionsAccounting for Acquisitions

Acquisitor Pre- Merger

Target Firm (Book Value)

Target Firm (Fair Market

Value)Acquisitor Post

Merger

Current assets 10,000 1,200 1,300 11,300Long-term assets 6,000 800 900 6,900Goodwill 100Total Assets 16,000 2,000 2,200 18,300

Current liabilities 8,000 800 800 8,800Long-term debt 2,000 200 250 2,250Common stock 2,000 400 1,250 3,250Retained earnings 4,000 600 4,000Total Claims 16,000 2,000 2,300 18,300

Book Values are not

relevant.

Acquisitor Value pre merger + Target Firm (FMV) = Acquisitor Post MergerGoodwill = Price paid – MV of Target firm Equity

= $1,250 – (MV of target assets – MV of target Liabilities)

= $1,250 – ($2,200 - $1,050)

= $100


Good Will in Subsequent YearsGood Will in Subsequent YearsThe Purchase MethodThe Purchase Method

• Good will is subject to an impairment test each Good will is subject to an impairment test each year.year.

• This will require FMV estimating using discounted This will require FMV estimating using discounted cash flow approaches annually following the cash flow approaches annually following the acquisition and capitalization of good will on the acquisition and capitalization of good will on the balance sheet.balance sheet.

• Good will is changed only if it is ‘impaired’ in Good will is changed only if it is ‘impaired’ in subsequent years resulting in a write down and a subsequent years resulting in a write down and a charge against earnings.charge against earnings.


Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:– The various forms of business combinations The various forms of business combinations

– The common motives that exist for takeovers as well as The common motives that exist for takeovers as well as the desirable characteristics of potential takeover “targets”the desirable characteristics of potential takeover “targets”

– How to evaluate a potential takeover candidate using the How to evaluate a potential takeover candidate using the multiples approach and using discounted cash flow multiples approach and using discounted cash flow analysisanalysis

– How acquisitions should be accounted for in the financial How acquisitions should be accounted for in the financial statements including the impact that acquisitions can have statements including the impact that acquisitions can have on EPS.on EPS.

Concept Review QuestionsConcept Review Questions



Concept Review Question 1Concept Review Question 1Acquisition versus MergerAcquisition versus Merger

What is the difference between an acquisition What is the difference between an acquisition and a merger?and a merger?


CopyrightCopyright

Copyright © 2007 John Wiley & Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Sons Canada, Ltd. All rights reserved. Reproduction or reserved. Reproduction or translation of this work beyond that translation of this work beyond that permitted by Access Copyright (the permitted by Access Copyright (the Canadian copyright licensing Canadian copyright licensing agency) is unlawful. Requests for agency) is unlawful. Requests for further information should be further information should be addressed to the Permissions addressed to the Permissions Department, John Wiley & Sons Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may The purchaser may make back-up copies for his or her make back-up copies for his or her own use only and not for distribution own use only and not for distribution or resale.or resale. The author and the The author and the publisher assume no responsibility publisher assume no responsibility for errors, omissions, or damages for errors, omissions, or damages caused by the use of these files or caused by the use of these files or programs or from the use of the programs or from the use of the information contained herein.information contained herein.

Chapter 15 mergers and acquisitions

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