Mergers and Acquisitions Chapter Twenty-Three Mergers and Acquisitions Prepared by Anne Inglis, Ryerson University

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 a paying for an acquisition Understand the various defensive tactics that are available

Chapter Outline The Legal Forms of Acquisitions Taxes and Acquisitions Accounting for Acquisitions Gains from Acquisition Some Financial Side Effects of Acquisitions The Cost of an Acquisition Defensive Tactics Some Evidence on Acquisitions

Merger versus Consolidation 23.1 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

Acquisitions A firm can be acquired by 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 different stages of the production process Conglomerate – firms are unrelated

Control of a firm transfers from one group to another Possible forms Takeovers Control of a firm transfers from one group to another Possible forms Acquisition Merger or consolidation Acquisition of stock Acquisition of assets Proxy contest Going private

Taxes 23.2 Tax-free acquisition Taxable acquisition Exchange of shares, no cash involved Continuity of equity interest – stockholders of target firm must be able to maintain an equity interest in the combined firm Generally, stock for stock acquisition Taxable acquisition Shares purchased with cash Assets are written up – affects depreciation expense

Accounting for Acquisitions 23.3 Pooling of interests accounting – Balance sheets of two firms are basically added together Purchase Accounting 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 Goodwill must be depreciated going forward Equity of acquired firm is bought out

Synergy 23.4 The whole is worth more than the sum of the parts Some mergers create synergies because the firm can either cut costs or use the combined assets more effectively This is generally a good reason for a merger Need to examine whether the synergies create enough benefit to justify the cost

Revenue Enhancement Marketing gains Strategic benefits Market power Advertising Distribution network Product mix Strategic benefits Market power

Economies of vertical integration Cost Reductions Economies of scale Ability to produce larger quantities while reducing the average per unit cost Most common in industries that have high fixed costs Economies of vertical integration Coordinate operations more effectively Reduced search cost for suppliers or customers Complimentary resources Video Note: The video entitled “Right Sizing” would be useful here. It looks at how operational restructuring at ABTCo increased the firm value substantially.

Take advantages of net operating losses Taxes Take advantages of net operating losses Carry-backs and carry-forwards Merger may be prevented if the IRS believes the sole purpose is to avoid taxes Unused debt capacity Surplus funds Pay dividends Repurchase shares Buy another firm Asset write-ups

Reducing Capital Needs A merger may reduce the required investment in working capital and fixed assets relative to the two firms operating separately Firms may be able to manage existing assets more effectively under one umbrella Some assets may be sold if they are redundant in the combined firm (this includes human capital as well)

Estimate only incremental cash flows Use an appropriate discount rate General Rules Do not rely on book values alone – the market provides information about the true worth of assets Estimate only incremental cash flows Use an appropriate discount rate Consider transaction costs – these can add up quickly and become a substantial cash outflow Video Note: The video entitled “Mergers and Acquisitions” looks at the events leading up to the merger between 2COMM and US Robotics.

Diversification Diversification, in and of itself, is not a good reason for a merger Stockholders can normally diversify their own portfolio cheaper than a firm can diversify by acquisition Stockholder wealth may actually decrease after the merger because the reduction in risk in effect transfers wealth from the stockholders to the bondholders

EPS Growth 23.6 Mergers 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 There is no free lunch

The NPV of a cash acquisition is Value of the combined firm is NPV = VB* – cash cost Value of the combined firm is VAB = VA + (VB* - cash cost) Often, the entire NPV goes to the target firm Remember that a zero-NPV investment is also desirable

Stock Acquisition Value of combined firm Cost of acquisition 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 Considerations when choosing between cash and stock Sharing gains – target stockholders don’t participate in stock price appreciation with a cash acquisition Taxes – cash acquisitions are generally taxable Control – cash acquisitions do not dilute control

Defensive Tactics 23.7 Corporate charter Establishes conditions that allow for a takeover Supermajority voting requirement Targeted repurchase aka greenmail Standstill agreements Exclusionary offers Poison pills (share rights plans) Leveraged buyouts Other defensive tactics Golden parachutes Crown jewels White knight

Evidence on Acquisitions 23.8 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 Shareholders 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

Quick Quiz What are the different methods for achieving a takeover? How do we account for acquisitions? What are some of the reasons cited for mergers? Which may be in stockholders’ best interest and which generally are not? What are some of the defensive tactics that firms use to thwart takeovers?

Summary 23.9 You should know: The forms of merger Tax issues that evolve from a taxable and tax-free acquisition Pooling and purchase methods How to value a merger Possible benefits from an acquisition – revenue enhancement, cost reduction, lower taxes and changing capital requirements Defensive tactics to an unfriendly acquisition