Mergers and Acquisitions Chapter 26 Mergers and Acquisitions Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Key Concepts and Skills Be able to define the various terms associated with M&A activity Understand the various reasons for mergers and acquisitions and whether or not these reasons are in the best interest of shareholders Understand the various methods for paying for an acquisition and how to account for it Understand the various defensive tactics that are available Understand how to value the transaction and estimate the gains from the merger or acquisition 26-1

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: Do M&A Pay? Divestitures and Restructurings 26-2

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 See the IM for multiple Lecture Tips that address merger activity over the past century, as well as the perceived downside of such activities (i.e., layoffs) that often result from mergers. 26-3

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 Real-World Tip: It is useful to give names to the various types of mergers. For example, McDonnell-Douglas/Boeing, Conoco/Phillips, and SBC/AT&T are all examples of horizontal mergers. An example of a vertical merger would be Texaco (excess refining capacity) and Getty Oil (significant oil reserves). U.S. Steel’s acquisition of Marathon Oil would be a conglomerate acquisition. 26-4

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 Lecture Tip: The popularity of proxy contests as a means of gaining control has waxed and waned over the last several decades. In the 1950s, this approach was a relatively popular means of removing target firm management; as noted previously, those who initiated proxy contests were even referred to in the popular press as “corporate raiders!” Empirical evidence suggests, however, that proxy contests are time-consuming, expensive for the dissident shareholder, and unlikely to result in complete victory. Tender offers came to the fore in the 1960s and 1970s. Some believe that the use of the proxy battle waned because of its relatively high cost and low probability of success. However, the ubiquity of takeover defenses and regulatory constraints has contributed to the return of the importance of the proxy battle as a means of gaining control. Real-World Tip: An interesting example of a long, drawn-out proxy battle appeared in The Wall Street Journal on October 8, 1996. Physician Steven Scott founded Coastal Physicians Group, Inc., but was subsequently ousted by its board of directors. Dr. Scott then filed suit and launched a proxy fight. In return, the firm’s management counter-sued and blamed him for the firm’s poor performance. Following several months of wrangling, two candidates backed by Dr. Scott won board seats. The struggle for control of Coastal is not unlike many proxy fights, in that they are often associated with claims and counter-claims, lawsuits, and a great deal of acrimony and expense. 26-5

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 26-6

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 26-7

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 26-8

Revenue Enhancement Marketing gains Strategic benefits Market power Advertising Distribution network Product mix Strategic benefits Market power Lecture Tip: The text notes several reasons for M&A activity. The following was sent via email to members of a mergers and acquisitions listserv. “Do you know a business experiencing a decline in sales, loss of direction, no longer competitive, ineffective management, … Or a business that’s being neglected by its corporate parent … Or a [sic] owner looking to retire that built a once successful business now needing reinventing … or a company that needs strong marketing, finance, and manufacturing disciplines … If you know such a business … it will be worth your while to reply.” 26-9

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 26-10

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 Lecture Tip: The IRS requires that the merger must have justifiable business purposes for the NOL carry-over to be allowed. And, if the acquisition involves a cash payment to the target firm’s shareholders, the acquisition is considered a taxable reorganization that results in a loss of NOLs. NOL carry-overs are allowed in a tax-free reorganization that involves an exchange of the acquiring firm’s common stock for the acquired firm’s common stock. Additionally, if the target firm operates as a separate subsidiary within the acquiring firm’s organization, the IRS will allow the carry-over to shelter the subsidiary’s future earnings, but not the acquiring firm’s future earnings. 26-11

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 reducing human capital as well) 26-12

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 Lecture Tip: One of the fathers of modern takeover theory is Henry Manne, who published “Mergers and the Market for Corporate Control” in 1965. In this seminal work, Manne proposes the (now commonly accepted) notion that poorly run firms are natural takeover targets because their market values will be depressed, permitting acquirers to earn larger returns by running the firms successfully. This proposition has been verified empirically in dozens of academic studies over the last four decades. 26-13

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 See the IM for a list of the top dealmakers. 26-14

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 Lecture Tip: In earlier chapters, we pointed out that conflicts of interest may exist between stockholders and managers in publicly traded firms. As noted above, diversification-based mergers don’t create value for shareholders (this was illustrated using option pricing theory in an earlier chapter); however, these mergers may increase sales and reduce the total variability of firm cash flows. If managerial compensation and/or prestige is related to firm size, or if less variable cash flows reduce the likelihood of managerial replacement, then some mergers may be initiated for the wrong reasons – they may be in the best interest of managers but not stockholders. 26-15

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 not undesirable 26-16

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 Lecture Tip: Emphasize that the logic used in determining the NPV of an acquisition is the same as that used to find the NPV of any other project. The acquisition is desirable if the present value of the incremental cash flows exceeds the cost of acquiring them. However, some financial theorists argue that many acquisitions contain a “winner’s curse.” The argument is that the winner of an acquisition contest is the firm that most overestimates the true value of the target. As such, this bid is most likely to be excessive. For a more detailed discussion of the “winner’s curse,” see Nik Varaiya and Kenneth Ferris, “Overpaying in Corporate Takeovers: The Winner’s Curse,” Financial Analysts Journal, 1987, vol. 43. no. 3. Richard Roll, in “The Hubris Hypothesis of Corporate Takeovers,” Journal of Business, 1986, vol. 59, no. 2, attributed the rationale for this behavior to hubris, i.e., the excessive arrogance or greed of management. 26-17

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 26-18

More (Colorful) Terms Golden parachute Poison put Crown jewel White knight Lockup Shark repellent Bear hug Fair price provision Dual class capitalization Countertender offer Each of these is defined in the IM. Lecture Tip: Less common, but not rare, are “reverse mergers,” in which a firm goes public by merging with a public (often shell) company. Ted Turner gained control of Rice Broadcasting (WJRJ-TV) in 1970 by doing a reverse merger. Rice Broadcasting was “virtually insolvent,” but by merging into a public company, Turner was obtaining financing for subsequent growth. 26-19

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, on average, do not earn or lose a large amount 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 Lecture Tip: It is probably not overstating the matter to say that the accepted wisdom in modern finance is that, in the aggregate, more merger and acquisition activity is preferred to less. Dozens of event studies report that, on average, the wealth of target firm stockholders is greatly enhanced, while the wealth of acquiring firm stockholders is unaffected, or at worst, slightly diminished. 26-20

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 26-21

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? 26-22

Ethics Issues In the case of takeover bids, insider trading is argued to be particularly endemic because of the large potential profits involved and because of the relatively large number of people “in on the secret.” What are the legal and ethical implications of trading on such information? Does it depend on who knows the information? 26-23

Comprehensive Problem Two identical firms have yearly after-tax cash flows of $20 million each, which are expected to continue into perpetuity. If the firms merged, the after-tax cash flow of the combined firm would be $42 million. Assume a cost of capital of 12%. Does the merger generate synergy? What is VB*? What is ΔV? The merger creates synergy since the combined firm cash flow is greater than the sum of the individual firm cash flows. The change in value is $2 million / .12 = 16.67 million VB* is the current value of $167 million ($20 million / .12) plus the change in value of 16.67 million = $184 million 26-24

End of Chapter 26-25