1. Corporate Finance MLI28C060
Merger and Acquisition: How these are undertaken and the implications of takeovers (corporate discipline)
Lecture 11
Monday 24 October 2016

2. Definition of Merger, Acquisition and Takeover

3. A Classification Scheme
Financial analysts typically classify acquisitions into three types:
Horizontal acquisition: when the acquirer and the target are in the same industry.
Vertical acquisition: when the acquirer and the target are at different stages of the production process; example: an airline company acquiring a travel agency.
Conglomerate acquisition: the acquirer and the target are not related to each other.

4. A Note on Takeovers
Takeover is a general and imprecise term referring to the transfer of control of a firm from one group of shareholders to another.
Takeover can occur by acquisition, proxy contests, and going-private transactions.
In a proxy contest, a group of shareholders attempts to gain controlling seats on the board of directors by voting in new directors.
A proxy authorizes the proxy holder to vote on all matters in a shareholders’ meeting.

5. Source of Synergy from Acquisitions
Revenue Enhancement
Cost Reduction
Including replacing ineffective managers.
Tax Gains
Net Operating Losses
Unused Debt Capacity
The Cost of Capital
Economies of Scale in Underwriting.

6. Mergers and Acquisitions as Part of FDI

7. Entry Strategies and Ownership Structures
DEVELOPED MARKETS
North America
Western Europe
Japan
Australia and New Zealand
% OF RESPONDENTS
Adapted from Figure 9–1: Preferred Strategies for Global Expansion

8. Entry Strategies and Ownership Structures
EMERGING MARKETS 20 40 60 80
100
% OF RESPONDENTS
Adapted from Figure 9–1: Preferred Strategies for Global Expansion

9. Implications of these on corporate valuation

10. The NPV of a Merger
Typically, a firm would use NPV analysis when making acquisitions.
The analysis is straightforward with a cash offer, but gets complicated when the consideration is stock.

11. The NPV of a Merger: Cash
NPV of merger to acquirer =
Synergy – Premium
Premium = Price paid for B - VB
NPV of merger to acquirer = Synergy - Premium

12. The NPV of a Merger: Common Stock
The analysis gets muddied up because we need to consider the post-merger value of those shares we’re giving away.

13. The three legal forms of acquisition are
Merger and consolidation
Acquisition of stock
Acquisition of assets
M&A requires an understanding of complicated tax and accounting rules.
The synergy from a merger is the value of the combined firm less the value of the two firms as separate entities.

14. Economic Gains and Distribution of Gains OH-Fut-Op 04/11/2017
copywrite

15. Economic Gains and Distribution of Gains
OH-Fut-Op
04/11/2017
Economic Gains and Distribution of Gains
1) Economic Gains
2) Distribution of Gains
- cash offer
- cash offer and underpriced
3) Distribution of Gains
- share offer
copywrite

16. Economic Gains Gains from a merger
OH-Fut-Op
04/11/2017
Economic Gains
Gains from a merger
Are the 2 firms worth more together than apart?
Assume current share prices correctly reflect each firm’s ‘stand alone’ value
Let
PVA = PA x NA = $200 x 1m = $200m (reflects PV of FCF)
PVB = $50m and assume PVAB = $275
copywrite

17. Economic Gains GainAB = PVAB - (PVA + PVB) - transactions costs
OH-Fut-Op
04/11/2017
Economic Gains
GainAB = PVAB - (PVA + PVB) - transactions costs
$25 = ( ) - 0
The difficulty is in assessing PVAB
Major difficulties in using NPV to assess the gains (‘synergies’)
is because of lack of data on FUTURE performance
of A+B, at the time of the takeover
Friendly takeover - more data may be available on value of A+B
Hostile takeover - much less data available on possible synergies
Scenario/sensitivity analysis will be used to estimate PVAB
copywrite

18. Distribution of Gains: Cash Offer
OH-Fut-Op
04/11/2017
Distribution of Gains: Cash Offer
Target ‘Correctly’ Priced in the market
‘A’ takeover of ‘B’: Gain for B= Cost for A
CostA = (cash paid - PVB ) = = $15m
This is the ‘bid premium’
This is a gain to B’s shareholders
Gain for A’s shareholders
GainA = GainAB - CostA = = $10m
Return to B’s shareholders = 15/50 = 30%
Return to A’s shareholders = 10/200 = 5%
copywrite

19. Distribution of Gains: Cash Offer
OH-Fut-Op
04/11/2017
Distribution of Gains: Cash Offer
Note:
If GainAB had been 10 (rather than 25) then A’s shareholders would loose from the merger:
GainA = GainAB - CostA = = -$5m
and PA would fall on announcement of merger terms
copywrite

20. Cash Offer: Target Underpriced
OH-Fut-Op
04/11/2017
Cash Offer: Target Underpriced
If PB << PVB : ie. B is underpriced
Then (for a given bid premium) more of the gains
go to A. ‘A’ can gain, even if there are
no synergies
(In this case there is not a gain for ‘society’, but a redistribution from B’s shareholders to A’s )
~ but note that A could ‘realise’ this gain by simply buying B’s shares (and not merging) and merely waiting for the ‘market correction’ that increases B’s price.
copywrite

21. Share Offer Assume A pays $65m for B (as with the cash offer)
OH-Fut-Op
04/11/2017
Share Offer
Assume A pays $65m for B (as with the cash offer)
We also have
PVAB = $275m, PVA = $200m, NA =1m and PA= $200
If B’s shareholders are to receive the equivalent of $65m
then
Number of (A’s) shares to be issued to B-shareholders
NB = PVB / PA (before merger) = $65m /$200 = 0.325m
This is announced BEFORE the actual merger takes place
Cost of bid to A depends on the share price of the merged company AFTER the merger
Assume Pay $65m for B
We also have PVAB = $275m PVA = $200m so let NA =1m PA= $200 )
Number of shares issued to B-shareholders
NB = PVB / PA (before merger) = $275m /$200 = 0.325m
Apparent(incorrect cost) = Nb PA(before) - PVB = 0.325(200)-50 = $15m
AFTER MERGER
NAB = 1.5m hence PAB = PVAB/ NAB = $275/1.5 = $207.55
Cost to A is:
CostA = (0.325/1.325) x $50m = m
= z PVAB PVB
z= share of the merged firm held by B
copywrite

22. Share Offer Apparent(but incorrect cost to A)
OH-Fut-Op
04/11/2017
Share Offer
Apparent(but incorrect cost to A)
= (200)-50 = $15m (as in ‘cash offer)
= NB PA - PVB
BUT correct’ cost of bid to A depends on the share price
of the merged company AFTER the merger
AFTER MERGER
NAB = 1.325m hence
PAB = PVAB/ NAB = $275/1.325 = $207.55
‘True’ Cost to A of shares given to B’s shareholders:
CostA = x $50m = m
Alternatively/equivalently
Cost to A of shares given to B’s shareholders:
CostA = (0.325/1.325) x $275m - $50m = m
= z PVAB PVB
where z = share of the merged firm held by B
copywrite

23. Cash versus Share Offer
OH-Fut-Op
04/11/2017
Cash versus Share Offer
CASH:
cost to A of the merger is unaffected
by the post-merger gains.
SHARES
Cost to A depends on the merger gains
PVAB , which show up in the post merger price, PAB
If cash is offered then the cost of the merger is unaffected by the post-merger gains. If shares are offered then the cost depends on the merger gains, which show up in the post merger price
copywrite

24. Valuation and Rationalization of Mergers & Acquisitions

25. Definitions
A merger is a combination of two or more corporations in which only one corporation survives and the merged corporations go out of business
Statutory merger is a merger where the acquiring company assumes the assets and the liabilities of the merged companies
A subsidiary merger is a merger of two companies where the target company becomes a subsidiary or part of a subsidiary of the parent company

26. Types of Mergers
Horizontal Mergers
- between competing companies
Vertical Mergers
- Between buyer-seller relation-ship companies
Conglomerate Mergers
- Neither competitors nor buyer-seller relationship

27. Motives and Determinants of Mergers
Synergy Effect
Operating Synergy
Financial Synergy
Diversification
Economic Motives
Horizontal Integration
Vertical Integration
Tax Motives

28. Equity Valuation Models
Firm valuation in M&A
Equity Valuation Models
Balance Sheet Valuation Models
Book Value: the net worth of a company as shown on the balance sheet.
Liquidation Value: the value that would be derived if the firm’s assets were liquidated.
Replacement Cost: the replacement cost of its assets less its liabilities.

29. Firm valuation in M&A-2
Dividend Discount Models

30. Firm valuation in M&A-3
The Constant Growth DDM

31. Firm valuation in M&A-4
Price-Earnings Ratio

32. P/E ratio and Stock index value

33. Firm valuation in M&A-5 Cash Flow Valuation Models
The Entity DCF Model : The entity DCF model values the value of a company as the value of a company’s operations less the value of debt and other investor claims, such as preferred stock, that are superior to common equity
. Value of Operations: The value of operations equals the discounted value of expected future free cash flow.
. Value of Debt
. Value of Equity

34. Firm valuation in M&A-6 What Drives Cash Flow and Value?
Fundamentally to increase its value a company must do one or more of the following:
. Increase the level of profits it earns on its existing capital in place (earn a higher return on invested capital)
. Increase the return on new capital investment
. Increase its growth rate but only as long as the return on new capital exceeds WACC
. Reduce its cost of capital.

35. Firm valuation in M&A-7
The Economic Profit Model: The value of a company equals the amount of capital invested plus a premium equal to the present value of the value created each year going forward.

36. Steps in Valuation
Analyzing Historical Performance

37. Steps in Valuation -2 Forecast Performance
Evaluate the company’s strategic position, company’s competitive advantages and disadvantages in the industry. This will help to understand the growth potential and ability to earn returns over WACC.
Develop performance scenarios for the company and the industry and critical events that are likely to impact the performance.
Forecast income statement and balance sheet line items based on the scenarios.
Check the forecast for reasonableness.

38. Steps in Valuation-3 Estimating The Cost Of Capital
Develop Target Market Value Weights
Estimate The Cost of Non-equity Financing
Estimate The Cost Of Equity Financing

39. Steps in Valuation-4 Estimating The Cost Of Equity Financing CAPM
. Determining the Risk-free Rate (10-year bond rate)
. Determining The Market Risk premium 5 to 6 percent rate is used for the US companies
. Estimating The Beta

40. Steps in Valuation-5 Estimating The Continuing Value
Selecting an Appropriate Technique
. Long explicit forecast approach
. Growing free cash flow perpetuity formula
. Economic profit technique

41. Steps in Valuation-6
Calculating and Interpreting Results
Calculating And Testing The Results
Interpreting The Results Within The Decision Context

42. Introduction to typical defenses against hostile takeover

43. Financing of Mergers CASH (TENDER) OFFER
OH-Fut-Op
04/11/2017
Financing of Mergers
CASH (TENDER) OFFER
Source of cash can be provided by the acquirer undertaking
a ‘rights issue’ or, by bank borrowing or, issuing debt
(e.g. LBO) or by using retained profits (‘free cash flows’)
- advantage to target shareholders is ‘precision’,
and free to re-invest the cash in any other company
- disadvantage is cash paid out may be treated as
realised capital gain and taxed.
- advantage for acquirer is that it retains total control of
the new merged firm (ie no ‘dilution’ for its shareholders
copywrite

44. Financing of Mergers SHARE OFFER
OH-Fut-Op
04/11/2017
Financing of Mergers
SHARE OFFER
- advantage to target shareholders is that any capital gain
on ‘new’ shares are not realised and hence not subject
to immediate capital gains tax
- advantage is target shareholder have (voting) shares
in the new company
-disadvantage to acquirer, if target (B) is overvalued by
stock market or bid premium is ‘too high’
MIXED OFFERs ARE ALSO USED:
Cash, shares, preference shares, share options
copywrite

45. Defensive Tactics
Target-firm managers frequently resist takeover attempts.
It can start with press releases and mailings to shareholders that present management’s viewpoint and escalate to legal action.
Management resistance may represent the pursuit of self interest at the expense of shareholders.
Resistance may benefit shareholders in the end if it results in a higher offer premium from the bidding firm or another bidder.

46. The Control Block and The Corporate Charter
If one individual or group owns 51-percent of a company’s stock, this control block makes a hostile takeover virtually impossible.
Control blocks are typical in Canada, although they are the exception in the United States.
The corporate charter establishes the conditions that allow a takeover.
Target firms frequently amend corporate charters to make acquisitions more difficult.
Examples
Staggering the terms of the board of directors.
Requiring a supermajority shareholder approval of an acquisition

47. Defence Tactics PAC MAN - mount a counter bid against the predator
OH-Fut-Op
04/11/2017
Defence Tactics
PAC MAN
- mount a counter bid against the predator
WHITE KNIGHT
- arrange another bid from a friendly company
POISON PILL
- make bid costly (e.g. your shareholders can buy shares
of new company at v. large discount.
Rights issue to dilute predators holdings )
POISON PUT (in bond covenants)
- bondholders of target can demand immediate repayment
in full, if there is a change in ownership
CROWN JEWELS
- sell off bits the acquirer is most interested in
copywrite

48. Defence Tactics GOLDEN PARACHUTES
OH-Fut-Op
04/11/2017
Defence Tactics
GOLDEN PARACHUTES
- managers get massive payoff if they are taken over
GREENMAIL
- bribe your shareholders with promise of large future
dividend payouts if they don’t sell their shares.
- buy-up shares promised to the predator, at a premium.
SHARK REPELLANTS
- supermajority (80%) to approve merger
- restricted voting rights (for shareholders who own
more than x% of stock)
staggered elections to the Board- more difficult to ‘capture’ the board so they recommend merger to their shareholders
copywrite