Merger and Acquisition

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Mergers and Acquisitions


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Merger activity in 2000-01

Acquiring Firm Selling Firm Payment ($ bn)

Vodafone Air Touch (UK) Mannesmann (Ger) 202.8

AOL Time Warner 106.0

Pfizer Warner-Lambert 89.2

Glaxo Wellcome (UK) SmithKline Beecham (US/UK) 76.0

Bell Atlantic GTE 53.4

Total Fina (Fr) Elf Aquitaine (Fr) 50.1

AT&T MediaOne 49.3France Telecom (Fr) Orange (UK) 46.0

Viacom CBS 39.4

Chase Manhattan J.P. Morgan 33.6

Source: Mergers and Acquisitions


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Types of transactions

Mergers, acquisitions, takeovers and buyouts are types oftransactions that change the ownership of firms

During the period 1980-2000, the distribution of suchtransactions among US nonfinancial firms was as follows:

There were 4,686 mergers, acquisitions and takeovers worth$3,258 billion in aggregate market equity value

There were 465 buyouts worth $60 billion

There were 337 reverse buyouts worth $65 billion


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A merger is the complete absorption of one firm by another andin this scenario we refer to an acquisition that takes place infriendly terms

The acquiring firm retains its identity and acquires all the assetsand liabilities of the acquired firm that ceases to exist and, thus,such transactions are also called acquisitions (e.g. theacquisition of McDonnell Douglas by Boeing)

In a consolidation, both firms cease to exist and a new firm iscreated after the acquisition (e.g. Peco Energy and Unicommerged to form the new utility firm Exelon)


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In the typical merger, the stockholders of the ceased firmreceive either cash or shares in the surviving firm

The acquiring firm makes an offer to the stockholders of theacquired (or target) firm to purchase their shares through cash,shares in the new firm or both

Another form of an acquisition is for the acquiring firm to

purchase all the assets of the acquired firm, but this may be acostly procedure


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Acquisitions can be Horizontal: a firm acquires another firm in the same industry

(DaimlerChrysler in 1998)

Vertical: a firm acquires another firm in a different stage (backward

or forward) of the production process (GM - Fisher Body) Conglomerate (merger): combination of two firms in unrelated

industries (Mobil OilMontgomery Ward in 1974)

A takeover is the purchase of one firm by another firm

If the takeover is friendly, then it is basically an acquisition, but ifnot, then it is known as hostile takeover (IBMs acquisition ofLotus in 1995; Oracles bid for PeopleSoft in 2003)


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Mechanics of M&As

Antitrust Law

Proposed merger must pass scrutiny by the Department of Justice

and the Federal Trade Commission (FTC)

Clayton Act (1914) forbids acquisitions that may substantiallylessen competition or tend to create a monopoly

The government may forbid a merger, or require the parties todivest some assets before the merger is completed in order tolessen market power in a particular sector


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M&A accounting

From an accounting standpoint, a merger or acquisition can be

treated as a purchase of assets or a pooling of interests

Under the pooling of interest approach

Stock is exchanged between the two firms

The balance sheet of the merged firm is nothing more than the twoseparate balance sheets added together


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Under the purchase of assets method, the acquiring firm buysthe target firm using cash

If the acquiring firm pays a premium over the target firms bookvalue (e.g. for intangible assets, such as a promising newtechnology developed by the target), the difference is bookedagainst goodwill

Goodwill has to amortized and these charges reduce reportedincome, which most firms do not like and that is why the poolingof interests method is typically preferred


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Tax issues

An acquisition may be taxable or tax-free

In a taxable acquisition, the shareholders of the target firm paytaxes on capital gains because they have sold their shares

In a tax-free acquisition, the shareholders of the target firm whohave exchanged their shares are assumed to have no capitalgains or losses, as long as they continue to have a stake in thenew firm


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Reasons for M&As

Economies of scale from horizontal mergers (e.g. BP andAmoco expected to save $2 bn annually from operations)

Economies of scope from vertical mergers (integrate suppliers,such as in the case of GM and Delphi, but recent trend istowards outsourcing)

Complementarities: a small firm may have a unique product, butmay need the experience in marketing and sales of a maturefirm that may also be in need of new products


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Unused tax shields: a firm may acquire another (loss-making)firm to take advantage of tax-loss carry-forwards (IRS will objectif this is only reason for merger)

Excess cash/inefficiencies

A firm with excess cash can use it better by acquiring another firmwith good projects; a firm with excess cash can also become atarget of an acquisition if it is not investing the cash in positive NPVprojects

Acquisitions can also eliminate inefficiencies frequently related tobad management


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Other (not so good) reasons

for M&As

The target firm tries to avoid bankruptcy and chooses to beacquired (evidence shows these acquisitions not to be

successful)

The Hubris Hypothesis: the acquiring firms managementovervalue their ability to create value once they take control ofthe target firms assets

Managers motivations to build an empire may lead to severalacquisitions that end up destroy value (e.g. WorldCom)


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Gains from M&As

M&As imply gains for the acquiring firm if there are synergiesinvolved

This implies that there should be incremental net gains so thatthe value of the combined firm will be greater than the sum ofthe two stand-alone firms

The incremental net gains (synergies) are given by

V = V12(V1 + V2)


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The net incremental gains are shown by estimating theincremental cash flows from the acquisition, which are

FCF =

EBIT +

Depreciation -

Tax -

Capital

= Revenue - Cost - Tax - Capital

Benefits of M&As arise from

Revenues (improved marketing, increased market power,strategic gains from entering new industry)

Costs, taxes, cap. requirements (economies of scale and/orscope, better use of resources of another firm, benefits of taxshield, lower investment needs due to higher efficiency)


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How much does an

acquisition cost? To determine the cost of an acquisition, we must calculate how

much a firm has to give up in order to acquire another firm

The incremental net gain to firm 1 from acquiring firm 2 is givenby

V = V12(V1 + V2)

The value of firm 2 to firm 1 is

V2* = V2 + V


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Therefore, firm 1 should proceed with the acquisition if the NPVis positive

NPV = V2* - C > 0

where C gives the cost to firm 1 of acquiring firm 2

Firm 1 has two options: choose a cash acquisition or a stockacquisition


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Case 1: Costs of a cash

acquisition Suppose we have the following information about firms 1 and 2

and that firm 1 is considering acquiring firm 2

Firm 1 Firm 2

Price per share $20 $10

# of shares 25 10

Market value $500 $100


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Assume that

Both firms are 100% equity owned

The incremental net gain to firm 1 from acquiring firm 2 is $100

Firm 2 has decided not to sell for less than $150 ($100 firm value + $50

acquisition premium)

The value of firm 2 to firm 1 is

V2* = V2 + V = $100 + $100 = $200

The NPV of the cash acquisition is $200 - $150 = $50

After the acquisition, firm 1s value increases by $50 to $550 ($500 was

initial value) and firm 2s stockholders have captured $50 out of the$100 merger gains

Firm 1 continues to have 25 share and each share will be worth$550/25 = $22, meaning a gain of $2 per share


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Case 2: Costs of a stock

acquisition In a stock acquisition, the stockholders of firm 2 exchange their

shares for shares in the new firm

The merged firm will be worth

V12 = V1 + V2+ V = $500 + $100 + $100 = $700

Since firm 2s stockholders want to sell the firm for $150 theywill receive $150 worth of shares from firm 1 or $150/$20 = 7.5shares given the price of firm 1s shares


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The new firm has 25 + 7.5 = 32.5 shares worth $700 meaning a valueper share of $700/32.5 = $21.54, which is lower because firm 2sstockholders also own part of the new firm

What was the cost of acquiring form 2 to firm 1? Was it only $150?

The 7.5 shares of the merged firm owned by firm 2s stockholders areworth 7.5 $21.54 = $161.55

The NPV of the stock acquisition is

NPV = V2* - C = $200 - $161.55 = $38.45

which is lower than the NPV of the cash acquisition because firm 2sstockholders share some of the gains (but also the losses)


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Implications of cash or stock acquisitions

Using cash to finance an acquisition (merger) implies that the

cost is unaffected by the merger gains

Using stock is preferred if there is potential for overvaluation orundervaluation of either firm (e.g. if firm 1 overvalues firm 2 andpays more, the bad news from discovering this fact in the future

will be shared by both firm 1s and firm 2s stockholders)


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Market Reaction to Mergers

Empirical evidence has shown that upon announcement of amerger bid, on average:

Share price of the targetedcompany rise 16%

Share price of acquiringcompany are essentially unchanged (a fallof 0.7%)

Value of total package (buyer plus seller) rises on average by 1.8%

Sellers earn higher returns because

Buyers are typically substantially much larger firms that thesignificant gains from the merger do not affect the firms share price

More importantly, it is often the case that there is a competitionamong bidders, which increases the gains for the target firm


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Takeovers

Most M&As are friendly and negotiated by the two firmsmanagements and boards

If a friendly acquisition is not possible and the acquiring firmwants to take control of the target firm, the acquiring firm can

Try to get the support of the target firms stockholders in the nextannual meeting (proxy fight)

Go directly to the target firms stockholders and make them atender offer to sell their shares


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Motives for takeovers

Failure of target firms management may attract corporateraiders

Firms that have grown as a result of inefficient diversificationmay become targets of a bust-up takeover where the firmsassets are divested so that it becomes more focused andefficient

Based on the hubris hypothesis, the target firms managementmay resist the takeover because they do not accept theargument that the acquiring firms management can run the firmbetter


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Takeover defenses

Pre-offer defenses

Some firms adopt so-called shark-repellent charter amendments

to deter potential bidders

Staggered boards (board is staggered in groups with only onegroup elected each year, thus making it more difficult for bidders togain control)

Require supermajority (above 80%) to approve a merger Restrict mergers unless a fair price is received

Unwelcome acquirers must wait a number of years before a mergercan be completed


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Other pre-offer defenses include Poison pills: Existing shareholders are issued the right to buy stock

at a discount if there is a significant purchase of shares by anoutside bidder

Poison put: Bondholders can demand repayment if there is ahostile takeover

Post-offer defenses

Issue new shares or repurchase shares from shareholders at apremium

Buy assets that the bidder does not want or that can createantitrust problems


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To eliminate resistance from management, the stockholders ofthe target firm may offer their managers a golden parachute

This is a generous payoff if the managers lose their job after thetakeover

This benefits of the takeover will outweigh this cost for

stockholders in such a scenario

Merger and Acquisition

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