©2009 McGraw-Hill Ryerson Limited 1 of External Growth Through Mergers External Growth Through Mergers Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

2 of 23 Chapter 20 - Outline Business Combinations Negotiated versus Tendered Offers Motives for Business Combinations Terms of Exchange Accounting, Financial and Organizational Considerations in Mergers and Acquisitions Summary and Conclusions

©2009 McGraw-Hill Ryerson Limited 3 of 23 Learning Objectives 1.Outline some defensive measures taken to avoid an unfriendly takeover. (LO1) 2.Identify the motives for mergers and divestitures, including financial considerations and the desire to increase operating efficiency. Also, perform an NPV analysis for a merger proposal. (LO2)

©2009 McGraw-Hill Ryerson Limited 4 of 23 Learning Objectives 3.Explain acquisition through cash purchases or by one company exchanging its shares for another company’s shares. (LO3) 4.Evaluate the impact of the merger on earnings per share and share value. (LO4) 5.Discuss the diversification benefits of a merger. (LO5) 6.Outline the reasons for using a holding company. (LO6)

©2009 McGraw-Hill Ryerson Limited 5 of 23 3 Types of Mergers Horizontal Merger: – unites direct competitors – e.g. 2 competing shoe companies combine – closely regulated by governments as reducing competition Vertical Merger: – unites buyers and sellers – e.g. a shoe manufacturer buys a leather producer Conglomerate Merger: – merging of firms in totally unrelated industries – e.g. a shoe company joins with a beverage company LO1

©2009 McGraw-Hill Ryerson Limited 6 of 23 Table 20-1 Largest mergers and acquisitions Value BuyerAcquired Company($ U.S. billions)Year 1.America Online....Time Warner$ Vodaphone Airtouch..Mannesmann Bell Atlantic.....GTE SBC Communications.Ameritech Exxon Mobil Royal Dutch petroleumShell Transport and Trading Vodaphone.....Airtouch Pfizer Warner-Lambert AT&TInc Bell South Comcast AT&T Broadband LO1

©2009 McGraw-Hill Ryerson Limited 7 of 23 Table 20-2 Largest mergers and acquisitions by Canadian companies Merger Partners Value (Cdn. billions) Year 1.BCE Ontario Teachers’ Pension Plan $ RioTinto......Alcan Inco CVRD Falconbridge....Xstrata Manulife Financial..John Hancock Thomson......Reuters Seagram......Polygram LO1

©2009 McGraw-Hill Ryerson Limited 8 of 23 Measures to Avoid Takeovers 1. White Knight: -a friendly company agreeing to bid a higher price for the potential takeover target 2. Crown Jewels: -a prized division or asset sold by the target making the takeover less attractive 3. Targeted Repurchase (also called “Greenmail”): -an offer by the target to buy back the shares already purchased by the acquiring company by paying a premium LO1

©2009 McGraw-Hill Ryerson Limited 9 of 23 Measures to Avoid takeovers 4. Golden Parachutes: -Contracts to pay existing management rather large sums of money if the company is taken over and they lose their jobs 5. Taking on More Debt: -Taking on more debt making the target more expensive to acquire 6. Poison Pills (also known as Shareholders’ Rights Plans): -a plan allowing the targeted firm’s all shareholders excluding the potential acquirer to buy newly issued shares at very low price LO1

©2009 McGraw-Hill Ryerson Limited 10 of 23 Business Combinations Legal definition of amalgamation: -a statutory combination under one of the provincial corporations or companies acts, the Canada Corporations Act, or the Canada Business Corporations Act Merger (and acquisition) refers to a transaction by which two or more companies are combined either under a statutory amalgamation or by ownership, that is: - one firm buys a majority or all of the voting shares of another firm LO2

©2009 McGraw-Hill Ryerson Limited 11 of 23 Financial Motives for Business Combinations To reduce risk through diversification To improve financing posture -Larger firms enjoy greater access to capital -Greater financing capability may be achieved if the acquired firm has a strong cash position or low debt-equity ratio To obtain tax loss carry-forward benefit To gain synergistic effect -Synergy: the whole is greater than the sum of the parts (“2 + 2 = 5”) -Overlapping functions in production and marketing are eliminated -Engineering and administrative capabilities are meshed LO2

©2009 McGraw-Hill Ryerson Limited 12 of 23 Negotiated versus Tendered Offers Mergers can be either friendly or hostile. Negotiated Offer: - a deal negotiated friendly between participating corporations - agreed upon by all sides Tendered Offer: - the buyer’s proposal not accepted by the potential seller’s management and board of directors - the offer made by the buyer asking the potential seller’s shareholders to tender (i.e. sell) their shares to the buyer - a hostile takeover bid LO2

©2009 McGraw-Hill Ryerson Limited 13 of 23 Non-financial Motives for Business Combinations To expand management and marketing capabilities To acquire new products LO2

©2009 McGraw-Hill Ryerson Limited 14 of 23 Motives of Selling Shareholders To receive the acquiring company’s shares To diversify their holdings into many new investments To escape the bias against smaller businesses LO2

©2009 McGraw-Hill Ryerson Limited 15 of 23 Terms of Exchange the price to be paid for a potential acquisition factors to consider including: earnings, dividends, growth potential depend on the method of payment A. Cash Purchase -can be viewed as a capital budgeting decision B. Stock-for-Stock Exchange - a trade-off between an immediate gain or dilution in EPS and future growth LO3

©2009 McGraw-Hill Ryerson Limited 16 of 23 SmallExpandCorporation Total earnings $200,000$500,000 Shares of stock outstanding ,000200,000 Earnings per share......$4.00$2.50 Price-earnings ratio (P/E)...7.5x12x Market price per share....$30.00$30.00 Table 20-3 Financial data on potential merging firms LO4

©2009 McGraw-Hill Ryerson Limited 17 of 23 Table 20-4 Post-merger earnings per share Total earnings: Small ($200,000) + Expand ($500,000)...$700,000 Shares outstanding in surviving corporation: Old (200,000) + New (50,000) ,000 New earnings per share for Expand Corporation == $2.80 $700, ,000 LO4

©2009 McGraw-Hill Ryerson Limited 18 of 23 FIGURE 20-1 Risk reduction: portfolio benefits LO4

©2009 McGraw-Hill Ryerson Limited 19 of 23 Accounting Considerations in Mergers and Acquisitions A merger can be treated as either a pooling of interest or a purchase of assets 1. Pooling of Interest -companies combine their financial statements -no goodwill is created 2. Purchase of Assets -The transaction is treated as a purchase of an asset. -Any excess of purchase price over book value must be recorded as goodwill. -Goodwill can not be amortized, but can be written down if the fair value drops. LO5

©2009 McGraw-Hill Ryerson Limited 20 of 23 Financial Considerations in Mergers and Acquisitions 1. Market Value Maximization –To determine the potential impact on shareholder value in the new firm 2. Premium Offers and Stock Price Movements –Acquiring firms often offer 5 to 50 percent premium to get the targets. –High premiums are justified if synergy can be realized. –Acquirees have superior stock price performance. 3. Mergers and the Market for Corporate Control –Mergers are an effective way of forcing agent managers to maximize shareholder wealth. LO5

©2009 McGraw-Hill Ryerson Limited 21 of 23 Organizational Considerations in Mergers and Acquisitions A holding company is one that has control over one or more other firms. It allows effective corporate control with minimal equity investments. It also benefits from the isolation of the legal risks of the firms. Drawbacks are: -magnifying poor returns -complicating administrative policies and procedures -depressing share price LO6

©2009 McGraw-Hill Ryerson Limited 22 of 23 Summary and Conclusions Firms grow externally through mergers and acquisitions. Mergers can be friendly negotiated or become hostile. The targeted firm has plenty of defensive tactics at its disposal such as white knight and poison pills. Achieving synergistic effect is the greatest motive for a merger. There are other financial and non-financial motives for firms to merger.

©2009 McGraw-Hill Ryerson Limited 23 of 23 Summary and Conclusions A acquiring firm may pay cash (cash purchase) or its own stock (stock-for-stock exchange) for an acquisition. The method of payment has financial implications for both the acquirer and the acquiree. The acquiree’s shareholders appear to benefit from a merger due to high premium and superior stock price performance. The acquirer’s shareholders tend to gain over a long run.