©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston Chapter Theories of Mergers and Tender Offers

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2 Why do mergers occur? Economies of scale Transaction costs Mergers allow a reorganization of production processes so that plant scale may be increased to obtain economies of scale

Theories of Valuation Effects of M&A Value Increasing: Transaction costs efficiency, synergy, displinary Value reducing: agency costs Value neutral: hubris – winner’s curse ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4 Free-Rider Problem Problem of diffused, small shareholders –Small shareholders may not expend resources monitoring management performance in a diffusely held corporation –Shareholders simply free-ride on monitoring efforts of other shareholders and share in any resulting performance improvements of the firm

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5 Models of the Takeover Process Economic — competition vs. market power Auction types — Dutch, English Forms of games Types of equilibria — pooling, separating, sequential Types of bids — one, multiple Bidding theory — preemptive; successive bids

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6 Framework Total gains for both target and acquirer –Positive Efficiency improvement Synergy Increased market power

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 7 –Zero Hubris Winner's curse Acquiring firm overpays –Negative Agency problems Mistakes or bad fit

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8 Gains to target — all empirical studies show gains are positive Gains to acquirer –Positive — efficiency, synergy, or market power –Negative — overpaying, hubris, agency problems, or mistakes

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9 Sources of Value Increases from M&As Efficiency increases –Unequal managerial capabilities –Better growth opportunities –Critical mass –Better utilization of fixed investments

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10 Operating synergy –Economies of scale –Economies of scope –Vertical integration economies –Managerial economies

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 11 Diversification motives –Demand for diversification by managers/employees because they make firm-specific investments –Diversification for preservation of organization capital –Diversification for preservation of reputational capital

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 12 Financial synergies –Complementarities between merging firms in matching the availability of investment opportunities and internal cash flows –Lower cost of internal financing — redeployment of capital from acquiring to acquired firm's industry –Increase in debt capacity which provides for greater tax savings –Economies of scale in flotation of new issues and lower transaction costs of financing

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13 Circumstances favoring merger over internal growth –Lack of opportunities for internal growth Lack of managerial capabilities and other resources Potential excess capacity in industry –Timing may be important — mergers can achieve growth and development of new areas more quickly –Other firms may be competing for investments in traditional product lines

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14 Strategic realignments –Acquire new management skills –Less time to acquire requisite capabilities for new growth opportunities or to meet new competitive threats

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15 The q-ratio –Ratio of the market value of the firm's securities to the replacement costs of its assets High q-ratio reflects superior management Depressed stock prices or high replacement costs of assets cause low q-ratios –Undervaluation theory Acquiring firm (A) seeks to add capacity; implies (A) has marginal q-ratio > 1 More efficient for (A) to acquire other firms in industry that have q-ratios < 1 than building a new facility

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16 Information –New information generated during tender offer process causes target firm share to be permanently revalued upward even if offer is unsuccessful –Two information hypotheses ”Sitting on a gold mine" — tender offer disseminates information that target shares are undervalued ”Kick in the pants" — tender offer forces target firm management to implement more efficient business strategies –Synergy explanation — upward revaluation in unsuccessful offer merely reflects likelihood that other bidders may surface with specialized resources to apply to target

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 17 Signaling –Information — an outside event not initiated by the firm conveys information –Signaling — particular actions by the firm may convey other significant forms of information, e.g., that management does not tender at the premium price in a share repurchase signals that the company's shares are undervalued

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18 Winner's Curse and Hubris Winner's Curse: The winning bid in a bidding contest for an object of uncertain value will typically pay in excess of its true value One cause of the winner's curse phenomenon in M&As is hubris, defined as overweening pride and excessive optimism

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19 Agency Problems Agency problems arise when managers own only fraction of the ownership shares of the firm –Managers may work less (shirk) and/or overconsume perks –Individual shareholders have little incentive to monitor managers –Dealing with agency problems give rise to monitoring and controlling costs

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 20 Solutions to agency problem –Organizational mechanisms –Compensation arrangements tied to performance –Market mechanisms Market for managers External monitoring through stock market Takeovers — external control device of last resort

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 21 Managerialism –Mergers are a manifestation of agency problems –Managers are motivated to increase the size of their firms because their compensation is a function of firm size, sales, or total assets –Theory may not be valid if managers' compensation is based on profitability or value increases

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22 Free Cash Flow Hypothesis (FCFH) Jensen (1986, 1988) Free cash flows (FCF) are cash flows in excess of the amount needed to fund all positive net present value projects link