Mergers and Acquisitions 25 Mergers and Acquisitions

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

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: Does M&A Pay? Divestitures and Restructurings

Merger versus Consolidation 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 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

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 Tax-free acquisition Taxable acquisition Business purpose; not solely to avoid taxes 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 Firm purchased with cash Capital gains taxes – stockholders of target may require a higher price to cover the taxes Assets are revalued – affects depreciation expense

Accounting for Acquisitions Pooling of interests accounting no longer allowed Purchase Accounting Assets of acquired firm must be reported at fair market value Goodwill is created – difference between purchase price and estimated fair market value of net assets Goodwill no longer has to be amortized – assets are essentially marked-to-market annually and goodwill is adjusted and treated as an expense if the market value of the assets has decreased

Synergy 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 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

Cost Reductions Economies of scale Economies of vertical integration 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

Taxes Take advantage of net operating losses Unused debt capacity 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)

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

EPS Growth 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

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

Cash Acquisition The NPV of a cash acquisition 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 Corporate charter Establishes conditions that allow for a takeover Supermajority voting requirement Targeted repurchase A.K.A. greenmail Standstill agreements Poison pills (share rights plans) Leveraged buyouts

More (Colorful) Terms Golden parachute Poison put Crown jewel White knight Lockup Shark repellent Bear hug Fair price provision Dual class capitalization Countertender offer

Evidence on Acquisitions 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 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

Divestitures and Restructurings 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 Split-up – company is split into two or more companies and shares of all companies are distributed to the original firm’s shareholders

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? How can a firm restructure itself? How do these methods differ in terms of ownership?

End of Chapter