CHAPTER 30: MERGERS AND ACQUISITIONS Topics: 30.1 Background 30.4-30.5 Synergy 30.6, 30.7, 30.9 NPV Analysis of Mergers 30.10 Defensive Tactics 30.11 Empirical Evidence This set of slides is a brief introduction to Chapter 30.

Background Merger: Companies A and B become one company (A+B) via an agreement which is Negotiated between the firms’ boards Subsequently voted on by shareholders Company B receives some number of company A shares, plus also (perhaps) some cash.

Background Acquisition: One company (or individual) A buys a controlling stake of company T. Management/board approval not required No shareholder meeting/vote required Accomplished by tender offer: a public offer made to each shareholder independently. May be cash, stock or some combination thereof. Tender offers are typically conditional. E.g., if more than 50% of shareholders do not tender, then offer is canceled. Usually the parties can be classified as: acquirer & target In most cases, a substantial premium is paid M&A activity has been quite extensive in the past two decades.

Types Friendly vs. hostile Cash vs. stock merger Mergers are almost always considered friendly Acquisitions may be hostile: resisted by the target’s management and board. Cash vs. stock merger

Common defensive tactics in Hostile acquisition Supermajority agreements (approval of a specified majority (usually 2/3 or ¾) of the acquired firm’s shareholders) Poison Pill Agreement (Shareholder rights plans) Existing shareholders are given the right to acquire shares at half-price. Acquirer’s rights are cancelled. Greenmail: payoff to acquirer to drop the bid Golden parachutes White knight Proxy contest: One group of shareholders attempt to gain controlling seats on the board by voting out the board of directors. A response to defensive tactics

The Inco M & A case: The players Primary products: Nickle, 2005 sales: $4.5 billion US. Based in Toronto Falconbridge Primary products: Copper and nickle, 2005 sales: $8.1 billion US. Based in Toronto Xstrata Copper, coking coal etc, 2005 Sales: $8 billion US. Based in Switzerland. Phelps Dodge Corp. Primary products: copper, 2005 sales: $8.3 billion US. Based in Arizona Teck Cominco Primary products: zinc, metallurgical coal, coper, 2005 sales: $4.4 billion Cdn. Based in Vancouver Companhia Vale do Rio Doce (CVRD) Largest global producer of iron ore and pellets. Based in Brazil.

Case cont’d: From Hunter to Hunted Oct. 2005: Inco announced a friendly takeover to buy Falconbridge for $12 billion Xstrata submitted a hostile takeover bid for Falconbridge May 2006: Teck Cominco submitted a hostile takeover bid to purchase Inco for $16 billion if it agreed to abandon its takeover of Falconbridge. June 2006: Phelps Dodge submitted a friendly takeover to buy a combined Inco and Falconbridge for around $40 billion; offer withdrawn due to the failure of the Inco-Falconbridge merger. August 2006: Brazilian mining company CVRD extended an all-cash offer to buy Inco for $17 billion. Now Inco becomes CVRD Inco. The Xstrata bid was successful, but not before Falconbridge employed a poison pill to delay the acquisition, raising its share price from $28 to $62.50. (firm value:$23.8bn)

Why merge? To justify a merger we need to show that PV(A + B) > PV(A) + PV(B) If so, there are synergies: Synergy = PV(A+B) – [PV(A) + PV(B)] NPV of merger to acquirer = Synergy – Premium

Sources of synergy (see section 30.5) increased revenues reduced costs Including replacing ineffective managers tax benefits Net operating losses Unused debt capacity reduced cost of capital Economies of scale

Valuation of Synergy In principle, synergy can be determined using the standard DCF approach: In practice, it is difficult to determine synergy it is hard to estimate incremental cash flows precisely discount rate – should reflect risk associated with use of funds there are also costs to consider (e.g. transaction costs)

How to pay for the target: Cash or stock? assuming that synergies have been calculated (i.e. the PV of the benefits of a merger), the next step is to assess the costs involved simple when cash is paid - the value of the merger to the acquiring firm is simply the synergies minus the PV of the costs with a stock offer, the costs depend on the gains because the post-merger stock price depends on the gains

Example Before a merger announcement: Suppose that synergies have been determined to be $4,750,000 (due to cost savings)

Example cont’d: Cash offer Cash offer: Assume that A will pay $12 million for B. Then the premium paid is $3 million and NPVA = However, this assumes that B’s current market price accurately reflects its value as a separate entity. What if takeover rumours have already increased B’s share price by $2?

Example cont’d: Stock offer Suppose that A will offer 160,000 shares instead of $12 million cash. The apparent premium being paid is However, note that the total value after the merger is This means that the new share price will be: so the real premium is How can the terms be set so that the premium is really $3 million?

Cont’d: solution Premium = 3m = Pnew x Nb – 9m α = % of merged firm owned by B’s S/H α = B’s value/total firm value post merge = = B’s shares/total shares = NB = Pnew = Verify: Premium = 76.75 (156,352) – 9m = 3m

Choice of cash or stock If A’s management believes its shares are undervalued by the market, then it will tend to prefer a cash offer. Conversely, if A’s management believes its shares are overvalued, it will tend to prefer a stock offer B’s S/H will likely figure this out if A makes a stock offer  signal that A’s shares are overvalued B’s S/H will want better terms With a stock offer, B’s shareholders will share in any subsequent gains (if the merger ultimately proves to be very successful) and any subsequent losses (if it doesn’t).

Empirical evidence Do acquisitions help shareholders? most evidence suggests that shareholders of target firms gain substantially, but shareholders in bidder firms do not bidder firm results are lower for stock offers than cash offers on average, the combined market values of bidders and targets do increase around the time of merger announcements diversifying acquisitions had positive bidder returns in the 1960s, but negative returns since then Do defensive tactics help target shareholders? evidence is mixed – on average, target stocks decline in value but there are many exceptions e.g. greenmail is most often viewed negatively, but if it is seen as giving management more time to find a better offer, it can be viewed positively by investors.

Who captures the value of synergy? ---Table 30.9 Stock Price Changes in Successful U.S. Corporate Takeovers

Realities of M&A Warren Buffet: “Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad's body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders… We've observed many kisses but very few miracles.” Buffet is right! In practice, targets almost always capture synergies

Assigned problems: # 30.1, 5-6