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SILVERLAKE

Chapter 23

DefinitionThe phrase mergers and

acquisitions (abbreviated M&A) refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling and combining of different companies that can aid, finance, or help a growing company in a given industry grow rapidly without having to create another business entity.

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Business valuation

The five most common ways to valuate a business are

asset valuation,historical earnings valuation,future maintainable earnings

valuation,relative valuation (comparable

company & comparable transactions),

discounted cash flow (DCF) valuation

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Chapter OutlineThe Legal Forms of AcquisitionsAccounting for AcquisitionsGains from AcquisitionThe Cost of an AcquisitionDefensive TacticsSome Evidence on AcquisitionsDivestitures and Restructurings

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Legal Forms of AcquisitionsMerger 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

Consolidation◦Entirely new firm is created from

combination of existing firms

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Stock Acquisition (1)A firm can be acquired by

purchasing voting shares of the firm’s stock

Tender offer – public offer to buy shares

Circular bid – takeover bid communicated to shareholders by direct mail

Stock exchange bid – takeover bid communicated to shareholders through a stock exchange

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Stock Acquisition (2)No stockholder vote requiredCan 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

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Acquisition ClassificationsHorizontal – both firms are in the

same industry

Vertical – firms are different stages of the production process

Conglomerate – firms are unrelated

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TakeoversControl of a firm transfers from

one group to anotherPossible forms

◦Acquisition◦Proxy contest◦Going private (LBO vs. MBO)

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Alternatives to MergerStrategic alliance = agreement

between firms to cooperate in pursuit of a joint goal

Joint venture = an agreement between firms to create a separate, co-owned entity established to pursue a joint goal

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Accounting for AcquisitionsThe Purchase Method

◦Assets of acquired firm are written up to fair market value

◦Goodwill is created – difference between purchase price and estimated fair market value of net assets

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Gains from AcquisitionSynergyRevenue enhancementCost reductionsTax gains

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SynergyThe whole is worth more than the

sum of the parts

Synergies should create enough benefit to justify the cost

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Revenue EnhancementMarketing gains

◦Advertising◦Distribution network◦Product mix

Strategic benefits

Market power

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Cost ReductionsEconomies of scale

◦Ability to produce larger quantities while reducing the average per unit cost

Economies of vertical integration◦Coordinate operations more

effectively◦Reduced search cost for suppliers or

customers

Complimentary resources

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TaxesTax losses

Unused debt capacity

Surplus funds

Asset write-ups∆FA = ∆EBIT + ∆Depreciation - ∆ Tax -

∆Capital Requirements

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Reducing Capital NeedsFirms may be able to manage

existing assets more effectively under one umbrella

Some assets may be sold if they are not needed in a combined firm

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Diversification Diversification, in and of itself, is

not a good reason for a merger

Stockholders can diversify their own portfolio cheaper than a firm can diversify by acquisition

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EPS GrowthMergers may create the appearance of

growth in earnings per share

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

In this case, the P/E ratio should fall because the combined market value should not change

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The Cost of Acquisition: Cash Acquisition

The NPV of a cash acquisition is◦NPV = VB* – cash cost

Value of the combined firm is◦VAB = VA + (VB* - cash cost)

◦VB* = VB + ∆V

Valuation Formulas 1. VA* = VA + VT + S - C 2. Price per share = VA*/number of shares 3. PT = price per share*number of shares + C (for

stock and mixed offers) 4. Target shareholders’ gain from transaction = PT - VT 5. VA* - value of the new company

VA – value of the acquirer VT – value of the target company S – synergies C – cash paid PT – price paid for the target company VT – pre-merger value of the target company PT = price per share*number of shares

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The Cost of Acquisition: Stock Acquisition

Value of combined firm◦ VAB = VA + VB + V

Cost 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◦ A B◦ Price $20 $10◦ # sh 25 10◦ Market value 500 100

Cash vs. Common StockCash VB* = VB + ∆V = 100 +100

NPV = 200 -150 =50VAB = VA + (VB* - cost) = 500+ 200 – 150 =550

Share price = 550/25 = 22

Stock acquisitionVAB = VA + VB + V =700

$150 in stock A is 7.5 shares (25+7.5=32.5 sh)700/32.5=21.54 a shareCost of acquisition is 7.5*21.54=161.55NPV = 38.45

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Cash vs. Common StockSharing rights

Taxes

Control

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Defensive Tactics(1)Corporate charter

◦Establishes conditions that allow for a takeover

◦Supermajority voting requirementTargeted repurchase (Greenmail)Standstill agreementsExclusionary offersPoison pills Share rights plans

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Defensive Tactics (2)Leveraged buyouts (LBO)Other defensive tactics

◦Golden parachutes◦Crown jewels◦White knight

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Evidence on AcquisitionsShareholders 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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More EvidenceShareholders of bidding firms do not

earn much excess return in either a tender offer or 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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Divestitures and Restructurings

Divestiture = sale of assets, operations, or divisions to a third party

Equity carve-out

Spin-off

Split-up