Mergers and Acquisitions

Chapter 29

Copyright © 2015 by the McGraw-Hill Education (Asia). All rights reserved.

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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 Outline29.1 The Basic Forms of Acquisitions29.2 Synergy29.3 Sources of Synergy29.4 Dubious Reasons for Acquisitions29.5 A Cost to Stockholders from Reduction in Risk29.6 The NPV of a Merger29.7 Friendly versus Hostile Takeovers29.8 Defensive Tactics29.9 Do Mergers Add Value?29.10 The Tax Forms of Acquisitions29.11 Accounting for Acquisitions29.12 Going Private and Leveraged Buyouts29.13 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 firm’s 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

Takeovers

Acquisition

Proxy Contest

Going Private(LBO)

Merger

Acquisition of Stock

Acquisition of Assets

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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:

Synergy =CFt

(1 + R)tt = 1

T

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29.3 Sources of Synergy Revenue Enhancement Cost Reduction

Replacement of ineffective managers Economy of scale or scope

Tax Gains Net operating losses Unused debt capacity

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 Dubious Reasons for 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).

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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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…

Both Firms Have 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 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 + ΔV) – cash paid = VB* – cash paid

Value of the combined firm is: VAB = VA + (VB* – cash paid)

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 + V Purchase price of acquisition

Depends on the number of shares given to the target stockholders

Depends on the price of the combined firm’s 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 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 previous 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 company’s stockholders

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Quick Quiz What are the different methods of 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?