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Advanced Accounting by Debra Jeter and Paul Chaney
Chapter 1: Introduction to Business Combinations Slides Authored by Hannah Wong, Ph.D. Rutgers University
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Types of Business Combinations
Friendly Combinations Boards of directors of both companies negotiate terms of proposed combination. Obj 1
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Types of Business Combinations
Unfriendly (Hostile) Combinations Board of directors of target company resists the combination. The acquiring company deals directly with individual shareholders through a tender offer. Obj 1
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Defense Tactics Poison pill: stock rights of shareholders to purchase additional shares at a bargain price in the event of a potential takeover. Greenmail: purchase of shares held by acquiring company at a premium price. Obj 4
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Defense Tactics White knight or white squire: encourage a friendly firm to acquire the target company. Selling the crown jewels: sale of valuable assets to make the firm less attractive. Leveraged buyout: managers and investors purchase controlling interests and take the firm private. Obj 4
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Business Combinations: Why?
Operating synergies Competitiveness in the international marketplace Financial synergy Diversification Divestitures ? ? ? ? ? Obj 2
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Business Combinations: Why Not?
Insufficient management control over the resulting conglomerate, resulting in future divestitures. Business combinations may enable suboptimal allocation of capital. Accounting method may encourage firms to pay too much. ? ? ? ? ? Obj 2
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Business Combinations: Historical Perspective
: horizontal integration : vertical integration 1945-present: merger mania 1970s: conglomerate mergers 1980s - present: strategic acquisitions Obj 1
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How it is accounted for:
Types of Combinations What is acquired: What is given up: How it is accounted for: Cash Purchase Method Net assets of S Company Debt Stock Common stock of S Company Combination of above Obj 5
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Stock Acquisition VS Asset Acquisition
may obtain control by acquiring 50% of voting common stock can avoid formal negotiation with target management maintain separate legal entity Asset Acquisition must acquire 100% of target firm, hence higher cost need to negotiate with target management no separate legal entity Obj 5
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Statutory Consolidation
Types of Combinations Statutory Merger A Company A Company B Company + Statutory Consolidation C Company A Company B Company + Stock Acquisition Consolidated Financial Statements of A and B Companies Financial Statements of A Company Financial Statements of B Company + Obj 5
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Determining Price Price Stock exchange ratio
effect of acquisition on future earnings value of the firm’s identifiable net assets estimated value of implied goodwill Stock exchange ratio number of shares of acquiring company to be exchanged for each share of the acquired company Obj 6
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Determining Method of Payment
Cash or stock? Factors affecting method of payment: liquidity position of acquiring firm willingness of sellers to accept alternative forms of payment tax and accounting issues Obj 6
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Estimate Implied Goodwill
By discounting expected future excess earnings identify normal rate of return for similar firms apply rate of return to net assets of target firm to estimate normal earnings estimate expected future earnings of target excess earnings = expected normal earnings earnings goodwill = discounted value of excess earnings - Obj 7
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Implied Goodwill Example Parent Co. is buying Sub Co.
Parent estimates Sub will earn $824,000 next year Companies similar to Sub Co. earned $532,000 last year Parent requires a 15% rate of return on this investment Parent assumes excess earnings will continue for seven years Obj 7
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Obj 7
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Advanced Accounting by Debra Jeter and Paul Chaney
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