Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. External Growth through Mergers 20

20-2 Chapter Outline Mergers as a means of increasing operating efficiency and for financial motives. Acquiring of companies through cash or the exchange of shares. Potential impact of mergers on earnings per share and assessment of stock value. Diversification benefits. Unfriendly buyouts.

20-3 Largest Acquisition Ever

20-4 Motives for Business Combinations Merger –A combination of two or more companies in which the resulting firm maintains the identity of the acquiring firm. Consolidation –Two or more companies combined to form a new entity. –Might be utilized when the firms are of equal size and market power.

20-5 Financial Motives Merger allow acquiring firms to enjoy a potentially desirable portfolio effect. Achieve risk reduction while maintaining the firm’s rate of return. –Variability in performance may be reduced due to opposite phases of the business cycle merge. Portfolio diversification becomes complicated with respect to practicalities. –It improves the financing posture as a result of expansion.

20-6 Financial Motives (cont’d) Larger firms may enjoy greater access to the capital market. Can attract larger and more prestigious investment bankers to handle future financing. –Greater financing may also be inherent of the merger itself especially likely when: The acquired firm has the strong cash position. A low debt-equity ratio that can be used to expand borrowing by the acquiring firm.

20-7 Tax Loss Carry-Forward May be available in a merger if one of the firms has previously sustained a tax loss. Assuming Firm A acquires Firm B, which has a $220,000 tax loss carry-forward. –The assumption is that the firm has a 40% tax rate. The tax shield value of a carry-forward to Firm A is equal to the loss involved times the tax rate ($220,000 X 40% = $88,000). –The company can reduce its total taxes from $120,000 to $32,000, and thus could pay $88,000 for the carry-forward alone. –The income available to stockholders also has increased by $88,000. Firm B’s anticipated operating gains and losses for future years must also be considered in analyzing the deal.

20-8 Tax Loss Carry-Forward (cont’d)

20-9 Non-Financial Motives Desire to expand management and marketing capabilities, and acquisition of new products. –May be directed toward vertical or horizontal integration. –Antitrust policies generally precludes the elimination of competition. –Management motivation - synergistic effect: Eliminating overlapping functions in production and marketing Meshing together various engineering capabilities.

20-10 Motives of Selling Stockholders Motivation can be from the probability of receiving the acquiring company’s stock. –Stockholders can diversify their holdings into new investments - If cash is offered. –Officers may receive attractive post-merger management contracts along with directorship of the acquiring firm. Bias against smaller businesses that has developed worldwide can be a motivation factor.

20-11 Cash Purchases Instead of purchasing new plant or machinery, the purchaser has opted to acquire a going concern. Assume that Firm A is considering the acquisition of Firm B for $1 million. Firm B has an expected cash flow (after-tax earnings plus depreciation) of $100,000 per year for the next 5 years and $150,000 per year for the 6 th through the 20 th year. –The synergistic benefits will add up to $10,000 per year to cash flow. –Firm B has a $50,000 loss carry-forward for immediate use. With a 40% tax rate, this will shield $20,000 of profit from taxes. –Firm A has a 10% cost of capital, and this is assumed to remain stable with the merger.

20-12 Cash Purchases (cont’d)

20-13 Cash Purchases (cont’d) The present value factor for the next five years is based on n = 5, i = 10%. For the 6 th through the 20 th years, the present value facto is taken for n = 20, i = 10%. The acquisition seems like a desirable option.

20-14 Stock-for-Stock Exchange Emphasis is laid on earnings per share impact of exchanging securities. Shareholders of the acquired firm are concerned with: –The initial price they are paid for their shares. –The outlook for the acquiring firm. Analysis is hence made mainly from the viewpoint of the firm.

20-15 Financial Data on Potential Merging Firms

20-16 Post-Merger Earnings Per Share

20-17 Possibilities of Mergers based on Stock-for-Stock Exchanges Acquiring firm increases its immediate earnings per share as a result of the merger: –But may slow its future growth rate if is buying a less aggressive firm. Acquiring firm may dilute immediate post- merger earnings per share: –But increase its potential growth rate for the future as a result of acquiring a rapidly growing firm.

20-18 Portfolio Effect The reduction or increase in risk may influence the P/E ratio as much as the change in the growth rate. –If the overall risk is reduced, there is an increase in post- merger P/E ratio and market value may increase. Business risk reduction: acquire another firm that is influenced by a set of factors opposite from those that influence the firm. Financial risk reduction: restructure the post-merger financial arrangements to include less debt. –If there is less risk in a firm, the investor may be willing to assign a higher valuation, thus increasing the P/E ratio.

20-19 Risk-Reduction Portfolio Benefits

20-20 Accounting Considerations in Mergers and Acquisitions Pooling of interests: –Acquiring firm issues only common stock, in exchange for mostly all of the other firm’s voting stock. –Acquired firm’s stockholders maintain an ownership position in the surviving firm. –Combined entity does not intend to dispose of a large portion of the assets of the merged firms within two years. –Combination is effected in a single transaction.

20-21 Purchase of Assets Goodwill may be created when assets purchase is involved. –Necessary when the tender offer is in cash, bonds, preferred stock, or common stock with restricted rights. FASB put SFAS 141 and SFAS 142 in place to eliminate pooling of interests accounting. –Placed on the balance sheet of the acquiring firm at the time of acquisition.

20-22 Evaluation of Goodwill Fair value of goodwill can be determined by taking present value of the future cash flows, and subtracting liabilities. –If the goodwill is impaired, part of it must immediately be written down against operating income. –The FASB also allows companies to take a one- time write-down of all past goodwill impairments at the time of adoption by the firm.

20-23 Negotiated versus Tendered Offers Traditionally, product lines, quality of assets, and future growth prospects have been discussed and an exchange ratio is agreed upon. –The takeover tender offer involves an attempt by a company to acquire a target firm against its will (McGraw-Hill – American Express). –Not all companies can fend off such unwanted advances.

20-24 Negotiated versus Tendered Offers (cont’d) Saturday night special: a surprise offer made just before the market closes for the weekend. –The impact may please the company’s stockholders. –The management faces danger of seeing the company going down the wrong path. White knight: a third firm that the management calls on to help it avoid the initial unwanted tender offer.

20-25 Protective Measures against a Takeover Tender Offer Moving the corporate offices to states that have tough pre-notification and protection provisions in regard to takeover bids. Buying back some of their own shares to restrict the amount of stock available for the takeover. Encouraging employees to buy stock under the pension plans. Increasing dividends.

20-26 Protective Measures against a Takeover Tender Offer (cont’d) Possible targets have also bought up other companies to increase their own size. Poison pills are also an effective device of protection.

20-27 Premium Offers and Stock Price Movements Most mergers are not acquired at their current market value. –A merger premium of 40-60% (or more) is paid over the pre-merger price of the acquired company. –Disadvantage: Much of the upside movement may occur before the public announcement. –Advantage: Good profits can be made after the merger is accomplished.

20-28 Premium Offers and Stock Price Movements (cont’d) Trouble with any merger-related investment strategy: –The merger may be called off. –Merger candidate’s stock, may fall back to the original value. Price may quickly rebound if there is merger negotiation with another company.

20-29 Stock Movement of Potential Acquirees

20-30 Two-Step Buyout The acquiring company attempts to gain control by offering a very high price of 51% of the shares outstanding. –Announces a second, lower price that will be paid off late, either in cash, stock, or bonds. –Provides a strong inducement to stockholders to quickly react to the offer. –Allows acquiring firm to pay a lower total price than if a single offer is made.

20-31 Two-Step Buyout (cont’d) The SEC keeps a close eye on this method. –Fears that smaller stockholders may not be informed enough to keep up with institutional investors. –Emphasizes the need for pro rata processing of stockholder orders. Each stockholder receives an equal percentage of shares tendered.