1. Mergers and Acquisitions
Chapter
Twenty-Three
Mergers and Acquisitions
Prepared by Anne Inglis, Ryerson University

2. Key Concepts and Skills
Be able to define the various terms associated with M&A activity
Understand the various reasons for mergers and whether or not those reasons are in the best interest of shareholders
Understand the various methods for a paying for an acquisition
Understand the various defensive tactics that are available

3. Chapter Outline
The Legal Forms of Acquisitions
Taxes and Acquisitions
Accounting for Acquisitions
Gains from Acquisition
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition
Defensive Tactics
Some Evidence on Acquisitions

4. Merger versus Consolidation 23.1
One firm is acquired by another
Acquiring firm retains name and acquired firm ceases to exist
Advantage – legally simple
Disadvantage – must be approved by stockholders of both firms
Consolidation
Entirely new firm is created from combination of existing firms

5. Acquisitions
A firm can be acquired by purchasing voting shares of the firm’s stock
Tender offer – public offer to buy shares
Stock acquisition
No stockholder vote required
Can deal directly with stockholders, even if management is unfriendly
May be delayed if some target shareholders hold out for more money – complete absorption requires a merger
Classifications
Horizontal – both firms are in the same industry
Vertical – firms are different stages of the production process
Conglomerate – firms are unrelated

6. Control of a firm transfers from one group to another Possible forms
Takeovers
Control of a firm transfers from one group to another
Possible forms
Acquisition
Merger or consolidation
Acquisition of stock
Acquisition of assets
Proxy contest
Going private

7. Taxes 23.2 Tax-free acquisition Taxable acquisition
Exchange of shares, no cash involved
Continuity of equity interest – stockholders of target firm must be able to maintain an equity interest in the combined firm
Generally, stock for stock acquisition
Taxable acquisition
Shares purchased with cash
Assets are written up – affects depreciation expense

8. Accounting for Acquisitions 23.3
Pooling of interests accounting – Balance sheets of two firms are basically added together
Purchase Accounting
Assets of acquired firm are written up to fair market value
Goodwill is created – difference between purchase price and estimated fair market value of net assets
Goodwill must be depreciated going forward
Equity of acquired firm is bought out

9. Synergy 23.4
The whole is worth more than the sum of the parts
Some mergers create synergies because the firm can either cut costs or use the combined assets more effectively
This is generally a good reason for a merger
Need to examine whether the synergies create enough benefit to justify the cost

10. Revenue Enhancement Marketing gains Strategic benefits Market power
Advertising
Distribution network
Product mix
Strategic benefits
Market power

11. Economies of vertical integration
Cost Reductions
Economies of scale
Ability to produce larger quantities while reducing the average per unit cost
Most common in industries that have high fixed costs
Economies of vertical integration
Coordinate operations more effectively
Reduced search cost for suppliers or customers
Complimentary resources
Video Note: The video entitled “Right Sizing” would be useful here. It looks at how operational restructuring at ABTCo increased the firm value substantially.

12. Take advantages of net operating losses
Taxes
Take advantages of net operating losses
Carry-backs and carry-forwards
Merger may be prevented if the IRS believes the sole purpose is to avoid taxes
Unused debt capacity
Surplus funds
Pay dividends
Repurchase shares
Buy another firm
Asset write-ups

13. Reducing Capital Needs
A merger may reduce the required investment in working capital and fixed assets relative to the two firms operating separately
Firms may be able to manage existing assets more effectively under one umbrella
Some assets may be sold if they are redundant in the combined firm (this includes human capital as well)

14. Estimate only incremental cash flows Use an appropriate discount rate
General Rules
Do not rely on book values alone – the market provides information about the true worth of assets
Estimate only incremental cash flows
Use an appropriate discount rate
Consider transaction costs – these can add up quickly and become a substantial cash outflow
Video Note: The video entitled “Mergers and Acquisitions” looks at the events leading up to the merger between 2COMM and US Robotics.

15. Diversification
Diversification, in and of itself, is not a good reason for a merger
Stockholders can normally diversify their own portfolio cheaper than a firm can diversify by acquisition
Stockholder wealth may actually decrease after the merger because the reduction in risk in effect transfers wealth from the stockholders to the bondholders

16. EPS Growth 23.6
Mergers may create the appearance of growth in earnings per share
If there are no synergies or other benefits to the merger, then the growth in EPS is just an artifact of a larger firm and is not true growth
In this case, the P/E ratio should fall because the combined market value should not change
There is no free lunch

17. The NPV of a cash acquisition is Value of the combined firm is
NPV = VB* – cash cost
Value of the combined firm is
VAB = VA + (VB* - cash cost)
Often, the entire NPV goes to the target firm
Remember that a zero-NPV investment is also desirable

18. Stock Acquisition Value of combined firm Cost of acquisition
VAB = VA + VB + V
Cost of acquisition
Depends on the number of shares given to the target stockholders
Depends on the price of the combined firm’s stock after the merger
Considerations when choosing between cash and stock
Sharing gains – target stockholders don’t participate in stock price appreciation with a cash acquisition
Taxes – cash acquisitions are generally taxable
Control – cash acquisitions do not dilute control

19. Defensive Tactics 23.7 Corporate charter
Establishes conditions that allow for a takeover
Supermajority voting requirement
Targeted repurchase aka greenmail
Standstill agreements
Exclusionary offers
Poison pills (share rights plans)
Leveraged buyouts
Other defensive tactics
Golden parachutes
Crown jewels
White knight

20. Evidence on Acquisitions 23.8
Shareholders of target companies tend to earn excess returns in a merger
Shareholders of target companies gain more in a tender offer than in a straight merger
Target firm managers have a tendency to oppose mergers, thus driving up the tender price
Shareholders of bidding firms do not earn much excess return in either a tender offer or a straight merger
Anticipated gains from mergers may not be achieved
Bidding firms are generally larger, so it takes a larger dollar gain to get the same percentage gain
Management may not be acting in stockholders best interest
Takeover market may be competitive
Announcement may not contain new information about the bidding firm

21. Quick Quiz
What are the different methods for achieving a takeover?
How do we account for acquisitions?
What are some of the reasons cited for mergers? Which may be in stockholders’ best interest and which generally are not?
What are some of the defensive tactics that firms use to thwart takeovers?

22. Summary 23.9 You should know: The forms of merger
Tax issues that evolve from a taxable and tax-free acquisition
Pooling and purchase methods
How to value a merger
Possible benefits from an acquisition – revenue enhancement, cost reduction, lower taxes and changing capital requirements
Defensive tactics to an unfriendly acquisition