1. 21-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Twenty-one Mergers, Acquisitions and Takeovers

2. 21-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 21.1The Legal Forms of Acquisitions 21.2Regulation of Business Combination 21.3Taxes and Acquisitions 21.4Gains from Acquisition 21.5Some Financial Side Effects of Acquisitions 21.6The Cost of an Acquisition 21.7Defensive Tactics 21.8Some Evidence on Acquisitions Summary and Conclusions Chapter Organisation

3. 21-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Discuss the legal forms of acquisitions. Understand the legal framework for mergers, acquisitions and takeovers. Discuss the gains from acquisition. Explain the financial side effects of acquisitions. Calculate the costs and NPV of an acquisition. Identify and discuss possible defensive tactics to a takeover attempt.

4. 21-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Legal Forms of Acquisitions Merger  complete absorption of one company by another. Consolidation  creation of a new firm by combining two existing firms. Advantages of mergers and consolidations: –simplicity (buyer assumes all assets and liabilities) –inexpensive. Disadvantages of mergers and consolidations: –shareholders of both firms must approve –difficulty in obtaining cooperation of target company’s management.

5. 21-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Legal Forms of Acquisitions Acquisition of assets  transfer of assets and liabilities of target company to acquiring company. –If the target company is listed on the stock exchange, the sale of its assets must be approved at a general meeting of its shareholders. Acquisition of shares (tender offer)  a public offer by one firm to directly buy the shares of another firm. Target company continues to exist. –Acquiring firm usually aims to acquire sufficient voting shares to gain management control

6. 21-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Degrees of Control Percentage of shares heldLegal position 100%Full ownership 90%Can compulsorily purchase remaining shares 75%Control to pass a special resolution at a general meeting 50%Majority control 20%Effective control (Corporations Act 2001 threshold level) 5%Must disclose shareholding (substantial shareholder)

7. 21-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Acquisition Classifications Horizontal acquisition  between two firms in the same industry. Vertical acquisition  the buyer expands backwards by acquiring a firm with the source of raw materials or forwards by acquiring a firm that is closer in the direction of the ultimate consumer. Conglomerate acquisition  involves companies in unrelated industries.

8. 21-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Activities Associated with Takeover Takeovers Acquisition Proxy contest Going private Merger or consolidation Acquisition of stock Acquisition of assets

9. 21-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Takeover Situations Creeping takeover –Holdings in a target company can be increased by no more than 3 per cent every six months. Off market bid –A formal written offer is made to acquire the shares of a target company. Market bid –An announcement by a stockbroker that a broking firm will stand in the market to purchase the target company’s shares for a specified price for a specified period.

10. 21-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Legal Framework Common law Enacted law (legislation) Stock Exchange Rules Contract lawLaw of tort Trade Practices Act 1974 Corporations Act 2001 Australian Securities Commission Act 1989 Corporations Regulations

11. 21-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Taxes and Acquisitions Generally, assets purchased after 19 September 1985 are subject to capital gains tax (CGT) when sold. CGT can be deferred under rollover provisions. CGT still applies when the consideration is shares, and when more than 50 per cent of pre-19 September 1985 shareholders have changed (regardless of purchase date).

12. 21-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Gains from Acquisition Synergy  the value of the combined companies is higher than the sum of the value of the individual companies. Need to determine incremental cash flows.

13. 21-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Incremental Cash Flows =  Revenue –  Cost –  Tax –  Capital requirements Increased revenues –Gains from better marketing efforts –Strategic benefits—‘beachhead’ into new markets –Increased market power—monopoly. Decreased costs –Economies of scale –Economies of vertical integration –Complementary resources.

14. 21-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Incremental Cash Flows (Continued) Tax gains –Use of net operating losses –Use of excess or unused franking credits –Use of unused debt capacity –Ability to write up the value of depreciable assets. Changing capital requirements –Reduced investment needs –More efficient asset management –Sell redundant assets.

15. 21-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Mistakes to Avoid Do not ignore market values. Estimate only incremental cash flows. Use the correct discount rate. Be aware of transactions costs.

16. 21-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Acquisitions and EPS Growth Pizza Shack and Checkers Pizza are merging to form Stop ’n’ Go Pizza. The merger is not expected to create any additional value. Stop ‘n’ Go, valued at $1 875 000, is to have 125 000 shares outstanding at $15 per share.

17. 21-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Acquisitions and EPS Growth (continued) Before and after merger financial positions 100 000 Stop ’n’ Go shares to Pizza Shack holders 25 000 Stop ’n’ Go shares to Checkers holders

18. 21-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Acquisitions and EPS Growth (continued) EPS has increased (and the P/E ratio has decreased) because the total number of shares is less. The merger has not ‘created’ value.

19. 21-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Diversification Does not create value in a merger. Is not, in itself, a good reason for a merger. Reduces unsystematic risk. BUT Shareholders can do this for themselves more easily and less expensively.

20. 21-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Cost of an Acquisition The net incremental gain from a merger of Firms A and B is:  V = V AB – (V A + V B ) The total value of Firm B to Firm A is: V B * = V B +  V The NPV of the merger is: NPV = V B * – Cost to Firm A of the acquisition

21. 21-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Cost of an Acquisition The cost of the acquisition to Firm A depends on the medium of exchange used to acquire Firm B— cash or shares. Whether cash or shares are used to finance the acquisition depends on: –Sharing gains: If cash is used, the selling firm’s shareholders will not participate in the potential gains (or losses) from the merger. –Control: Control of the acquiring firm is unaffected in a cash acquisition. Acquisition with voting shares may have implications for control of the merged firm.

22. 21-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Cash or Shares? Pre-merger information for Firm A and Firm B: Both firms are 100 per cent equity financed. The estimated incremental value of the acquisition is $500.

23. 21-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Cash or Shares? (Continued) Firm B has agreed to a sale price of $675, payable in cash or shares. The value of Firm B to Firm A is: How much does Firm A have to give up?

24. 21-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Cash Acquisition Cost of acquiring Firm B is $675. NPV of the cash acquisition is: The value of Firm A after the merger is: With 120 shares outstanding, the price per share after the merger is $18.21.

25. 21-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Share Acquisition The value of the merged firm: Firm A must give up $675/$15 = 45 shares. After the merger there will be 120 + 45 = 165 shares outstanding, valued at $2860/165 = $17.33 per share.

26. 21-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Share Acquisition True cost of the acquisition: 45 shares × $17.33 = $779.85 NPV of the merger to Firm A: Cash acquisition preferred (higher NPV).

27. 21-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Defensive Tactics Managers who believe their firms are likely to become takeover targets and who wish to fend off unwanted acquirers often implement one or more takeover defences. These defensive tactics take several forms: –Friendly shareholders offer the best defence. –Poison pills—designed to ‘repel’ takeover attempts. –Share rights plans—allow existing shareholders to purchase shares at some fixed price in the event of a takeover bid. –Going private and leveraged buyouts—the publicly owned shares in a firm are replaced with complete equity ownership by a private group (often financed by debt).

28. 21-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Terminology of Defensive Tactics Golden parachutes—compensation to top-level management. Poison puts—purchase securities back at a set price. Crown jewels—selling off of major assets. White knights—acquisition by a ‘friendly’ firm. Lockups—option for a ‘friendly’ firm to purchase shares or assets at a fixed price. Shark repellant—designed to discourage unwanted mergers.

29. 21-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Evidence on Acquisitions Shareholders of target companies involved in successful takeovers gain substantially. Abnormal gains to target firms’ shareholders of around 25 per cent. Reflects merger premium typically paid by the acquiring firm.

30. 21-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Evidence on Acquisitions Shareholders of bidding firms involved in successful takeovers only experience gains of 5 per cent. There are a variety of explanations for this: –Overestimated anticipated gains –Scale effect (bidders usually larger than targets) –Agency problem –Competitive market for takeovers –Gains already reflected in bidder’s price (no new information).

31. 21-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions The three legal forms of acquisition are: merger and consolidation, acquisition of shares, and acquisition of assets. An acquisition will benefit the shareholders of the acquiring firm if the value generated is greater than the cost of the acquisition. Sources of potential benefits of an acquisition include: revenue enhancement, cost reduction, lower taxes, and changing capital requirements. On average, shareholders of target firms do very well, while the shareholders of bidding firms do not appear to gain very much.