FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

FINANCE IN A FINANCE IN A CANADIAN SETTINGCANADIAN SETTING

Sixth Canadian EditionSixth Canadian Edition

Lusztig, Cleary, Lusztig, Cleary, SchwabSchwab

CHAPTER CHAPTER

TWENTY-SIXTWENTY-SIX

Mergers and AcquisitionsMergers and Acquisitions

Learning ObjectivesLearning Objectives

1. Identify the four types of external 1. Identify the four types of external expansion that a company may pursue.expansion that a company may pursue.

2. Define synergy, and explain what effect 2. Define synergy, and explain what effect it can have on a merged company.it can have on a merged company.

3. Describe some of the consequences for 3. Describe some of the consequences for the acquiring company when it is paying the acquiring company when it is paying more than the current market price for more than the current market price for the shares of the firm it is taking over.the shares of the firm it is taking over.

Learning ObjectionsLearning Objections

4. Identify the accounting concerns in an 4. Identify the accounting concerns in an acquisition, and discuss some of their acquisition, and discuss some of their implications.implications.

5. Discuss the major concerns involving 5. Discuss the major concerns involving corporate concentration, declining corporate concentration, declining competition, increased debt loads, competition, increased debt loads, insider trading, and other such topics.insider trading, and other such topics.

IntroductionIntroduction

Firms grow by generating new internal investments or by Firms grow by generating new internal investments or by acquiring businesses through external expansionacquiring businesses through external expansion

The framework for analyzing business combinations is The framework for analyzing business combinations is similar to capital budgetingsimilar to capital budgeting

Business combinations can take the form of:Business combinations can take the form of: Holding companiesHolding companies – a firm’s assets are shares of other – a firm’s assets are shares of other

companies (BCE, CP, ONEX)companies (BCE, CP, ONEX) MergersMergers – two firms come together, with one losing its – two firms come together, with one losing its

corporate identity and being absorbed by the othercorporate identity and being absorbed by the other AmalgamationsAmalgamations – also called consolidations, they are – also called consolidations, they are

common between equalscommon between equals

Motives for Motives for Business CombinationsBusiness Combinations

The main motive for business combination The main motive for business combination should be to enhance shareholder wealthshould be to enhance shareholder wealth

The factors that create shareholder wealth vary The factors that create shareholder wealth vary and are reflected through several directions and are reflected through several directions external growth can take, which include:external growth can take, which include: Horizontal expansionHorizontal expansion –– when a firm acquires when a firm acquires

competitors that produce or distribute similar competitors that produce or distribute similar productsproducts

Vertical integrationVertical integration –– occurs when successive occurs when successive stages of operation are integratedstages of operation are integrated

Motives forMotives for Business Combinations Business Combinations

Circular expansionCircular expansion – brings different products together – brings different products together that can be handled by similar technologies or that can be handled by similar technologies or distributed channelsdistributed channels

Conglomerate expansionConglomerate expansion – involves companies with – involves companies with products or businesses that bear no relation to one products or businesses that bear no relation to one anotheranother

SynergySynergy exists when the value of the combined company exceeds exists when the value of the combined company exceeds

the sum of the value of the two firms being mergedthe sum of the value of the two firms being merged can arise from economies of scalecan arise from economies of scale the greatest synergies involve intangible assetsthe greatest synergies involve intangible assets


Improved managementImproved management Market for corporate controlMarket for corporate control –– when acquisitions are when acquisitions are

used as tools for ousting underperforming managersused as tools for ousting underperforming managers many hostile takeovers are of this kindmany hostile takeovers are of this kind

Synergy-motivated takeovers or mergers are usually Synergy-motivated takeovers or mergers are usually friendly since the target firm’s managers have less friendly since the target firm’s managers have less reason to fear losing their positionreason to fear losing their position

Bargain PriceBargain Price when shareholders place too low a value on a when shareholders place too low a value on a

company’s shares a takeover may be profitable company’s shares a takeover may be profitable


Market powerMarket power Mergers lead to companies exercising market power, Mergers lead to companies exercising market power,

thereby controlling prices charged to consumersthereby controlling prices charged to consumers Improved financingImproved financing

A merger with an established firm opens project A merger with an established firm opens project financing opportunitiesfinancing opportunities

Tax considerationsTax considerations Search for liquidity and management skillsSearch for liquidity and management skills

Owners of private firms with no successor plan may be Owners of private firms with no successor plan may be forced to sell out to obtain liquidity for retirementforced to sell out to obtain liquidity for retirement

DiscountedDiscounted Cash Flow Analysis Cash Flow Analysis

The value an acquisition contributes to The value an acquisition contributes to the acquiring firm is given by the NPVthe acquiring firm is given by the NPVNPV = present value of incremental net future NPV = present value of incremental net future

cash flows that accrue because cash flows that accrue because of the of the acquisition acquisition

- the acquisition price- the acquisition price

The discount rate to compute the NPV The discount rate to compute the NPV must reflect the risk inherent in that must reflect the risk inherent in that firm’s cash flowsfirm’s cash flows


Because businesses have an indefinite economic Because businesses have an indefinite economic life, the selection of a proper time horizon is criticallife, the selection of a proper time horizon is critical

Alternative approaches to time horizon include:Alternative approaches to time horizon include:1. Choice of an arbitrary cut-off date1. Choice of an arbitrary cut-off date

2. Estimation of cash flows for a number of years, with 2. Estimation of cash flows for a number of years, with some assumptions regarding cash flows after that datesome assumptions regarding cash flows after that date

3. Projections of cash flows to a specified cut-off, followed 3. Projections of cash flows to a specified cut-off, followed by an assumed liquidation of the investment at that by an assumed liquidation of the investment at that time with estimated fair market valuetime with estimated fair market value


Firms that are liquid with unused debt Firms that are liquid with unused debt capacity are attractive takeover targets capacity are attractive takeover targets because the acquisition can be financed because the acquisition can be financed by the target company’s own financing by the target company’s own financing abilities after the takeoverabilities after the takeover

Leveraged buyoutsLeveraged buyouts – when the acquiring – when the acquiring firm puts up a minimal amount of equity, firm puts up a minimal amount of equity, using the expected cash flows and assets using the expected cash flows and assets of the target company to obtain debt of the target company to obtain debt financingfinancing

Accounting for Accounting for Business CombinationsBusiness Combinations

In Canada, surviving companies will In Canada, surviving companies will account for an acquisition through the account for an acquisition through the purchase methodpurchase method

Purchase methodPurchase method – when the assets of – when the assets of the firm being acquired are revalued the firm being acquired are revalued to reflect the purchase price and are to reflect the purchase price and are integrated into the acquiring firm’s integrated into the acquiring firm’s balance sheet at the revised valuebalance sheet at the revised value

Effects of Mergers on Effects of Mergers on Earnings Per ShareEarnings Per Share

Most mergers have an immediate Most mergers have an immediate and major impact on reported and major impact on reported earnings, which provides a strong earnings, which provides a strong misguided motive for some mergersmisguided motive for some mergers

Phantasmic growthPhantasmic growth – when growth in – when growth in EPS is achieved through mergersEPS is achieved through mergers

with firms having low with firms having low P/E ratiosP/E ratios

ProceduresProcedures

Legal aspectsLegal aspects The rules and regulations concerning business The rules and regulations concerning business

combinations are outlined in:combinations are outlined in: The Canadian Business Corporation ActThe Canadian Business Corporation Act Stock exchange regulationsStock exchange regulations

The regulations provide shareholders the The regulations provide shareholders the information and opportunity to participate in information and opportunity to participate in any final decisionany final decision

The main federal issue looked at in mergers The main federal issue looked at in mergers and acquisitions is competition policyand acquisitions is competition policy


Friendly combinationsFriendly combinations Business combinations occur through friendly Business combinations occur through friendly

negotiations between the management of the negotiations between the management of the two corporations or through a takeover bidtwo corporations or through a takeover bid

Major issues in the bargaining process Major issues in the bargaining process include:include:

price paid for the acquisitionprice paid for the acquisition synergies created by combining the synergies created by combining the

companiescompanies

ProceduresProcedures Tender offersTender offers

tender offertender offer –– the acquiring firm bypasses management and the acquiring firm bypasses management and makes a direct offer to shareholders of the targeted makes a direct offer to shareholders of the targeted companycompany

Management can fight unfriendly takeovers through:Management can fight unfriendly takeovers through:1. legal barriers1. legal barriers

2. poison pills2. poison pills

3. soliciting competing takeover bids from other firms3. soliciting competing takeover bids from other firms

4. company changes making it less attractive to the acquiring 4. company changes making it less attractive to the acquiring firmfirm

5. counter-attacks5. counter-attacks


Purchase of assets or sharesPurchase of assets or shares External expansion can be External expansion can be

accomplished through:accomplished through: purchasing another firms assetspurchasing another firms assets

attractive when target has contingent attractive when target has contingent liabilitiesliabilities

gaining a firm’s control by purchasing gaining a firm’s control by purchasing the company’s sharesthe company’s shares

in this case, both assets and liabilities in this case, both assets and liabilities are taken over by the parent companyare taken over by the parent company

Public Policy Implications Public Policy Implications of Business Combinationsof Business Combinations

Public concerns over past and Public concerns over past and future mergers include:future mergers include: corporate concentration and powercorporate concentration and power declining competitiondeclining competition foreign control and ownershipforeign control and ownership large debt loads restricting new large debt loads restricting new

investmentsinvestments

SummarySummary

1. The combination of separate business 1. The combination of separate business entities in the form of mergers, entities in the form of mergers, amalgamations, and the use of holding amalgamations, and the use of holding companies can achieve business companies can achieve business expansion externally for a firm. expansion externally for a firm. Ultimately, the driving force behind any Ultimately, the driving force behind any expansion should be a creation of value expansion should be a creation of value that increases shareholder wealth.that increases shareholder wealth.

SummarySummary

2. An acquisition should only be pursued if 2. An acquisition should only be pursued if it generates a positive net present it generates a positive net present value. Estimated future cash flows that value. Estimated future cash flows that accrue as a consequence of an accrue as a consequence of an acquisition should reflect any actions acquisition should reflect any actions that the new management may that the new management may implement, and the discount rate implement, and the discount rate applied should be commensurate with applied should be commensurate with the target firm’s perceived risk.the target firm’s perceived risk.

SummarySummary

3. Business combinations affect reported 3. Business combinations affect reported earnings per share (EPS), the shares’ price-earnings per share (EPS), the shares’ price-earnings (P/E) ratio, and market price of the earnings (P/E) ratio, and market price of the surviving entity. EPS, however, may grow if surviving entity. EPS, however, may grow if one firm acquires another whose shares trade one firm acquires another whose shares trade at a lower P/E ratio. at a lower P/E ratio.

4. Net assets of the acquiring firms are revalued 4. Net assets of the acquiring firms are revalued to reflect the purchase price actually paid, to reflect the purchase price actually paid, and incomes of the two businesses are pooled and incomes of the two businesses are pooled as of the date of acquisition.as of the date of acquisition.

SummarySummary

5. A combination may be arranged through 5. A combination may be arranged through negotiations between management followed negotiations between management followed by shareholder ratification or through a tender by shareholder ratification or through a tender offer. Reluctant management can pursue a offer. Reluctant management can pursue a variety of strategies to fend off an unfriendly variety of strategies to fend off an unfriendly takeover and to protect their own interests.takeover and to protect their own interests.

6. A variety of statutes dictate the rules under 6. A variety of statutes dictate the rules under which a business combination may occur which a business combination may occur because of economic concerns and past because of economic concerns and past abuses.abuses.

FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

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