1. 0 Merger versus Consolidation  Merger One firm is acquired by another One firm is acquired by another Acquiring firm retains name and acquired firm ceases to exist Acquiring firm retains name and acquired firm ceases to exist Advantage – legally simple Advantage – legally simple Disadvantage – must be approved by stockholders of both firms Disadvantage – must be approved by stockholders of both firms  Consolidation Entirely new firm is created from combination of existing firms Entirely new firm is created from combination of existing firms

2. 1 Acquisitions  A firm can be acquired by another firm or individual(s) purchasing voting shares of the firm’s stock  Tender offer – public offer to buy shares  Stock acquisition No stockholder vote required No stockholder vote required Can deal directly with stockholders, even if management is unfriendly 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 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 Horizontal – both firms are in the same industry Vertical – firms are in different stages of the production process Vertical – firms are in different stages of the production process Conglomerate – firms are unrelated Conglomerate – firms are unrelated

3. 2 Takeovers  Control of a firm transfers from one group to another  Possible forms Acquisition Acquisition Merger or consolidationMerger or consolidation Acquisition of stockAcquisition of stock Acquisition of assetsAcquisition of assets Proxy contest Proxy contest Going private Going private

4. 3 Taxes  Tax-free acquisition Business purpose; not solely to avoid taxes Business purpose; not solely to avoid taxes Continuity of equity interest – stockholders of target firm must be able to maintain an equity interest in the combined firm 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 Generally, stock for stock acquisition  Taxable acquisition Firm purchased with cash Firm purchased with cash Capital gains taxes – stockholders of target may require a higher price to cover the taxes Capital gains taxes – stockholders of target may require a higher price to cover the taxes Assets are revalued – affects depreciation expense Assets are revalued – affects depreciation expense

5. 4 Accounting for Acquisitions  Pooling of interests accounting no longer allowed  Purchase Accounting Assets of acquired firm must be reported at fair market value Assets of acquired firm must be reported at fair market value Goodwill is created – difference between purchase price and estimated fair market value of net assets Goodwill is created – difference between purchase price and estimated fair market value of net assets Goodwill no longer has to be amortized – assets are essentially marked-to-market annually and goodwill is adjusted and treated as an expense if the market value of the assets has decreased Goodwill no longer has to be amortized – assets are essentially marked-to-market annually and goodwill is adjusted and treated as an expense if the market value of the assets has decreased

6. 5 Synergy  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  Examine whether the synergies create enough benefit to justify the cost

7. 6 Revenue Enhancement  Marketing gains Advertising Advertising Distribution network Distribution network Product mix Product mix  Strategic benefits  Market power

8. 7 Cost Reductions  Economies of scale Ability to produce larger quantities while reducing the average per unit cost Ability to produce larger quantities while reducing the average per unit cost Most common in industries that have high fixed costs Most common in industries that have high fixed costs  Economies of vertical integration Coordinate operations more effectively Coordinate operations more effectively Reduced search cost for suppliers or customers Reduced search cost for suppliers or customers

9. 8 Taxes  Take advantage of net operating losses Carry-backs and carry-forwards Carry-backs and carry-forwards Merger may be prevented if the IRS believes the sole purpose is to avoid taxes Merger may be prevented if the IRS believes the sole purpose is to avoid taxes  Unused debt capacity  Surplus funds Pay dividends Pay dividends Repurchase shares Repurchase shares Buy another firm Buy another firm  Asset write-ups

10. 9 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)

11. 10 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

12. 11 EPS Growth  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

13. 12 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

14. 13 Cash Acquisition  The NPV of a cash acquisition is NPV = V B * – cash cost NPV = V B * – cash cost  Value of the combined firm is V AB = V A + (V B * - cash cost) V AB = V A + (V B * - cash cost)  Often, the entire NPV goes to the target firm  Remember that a zero-NPV investment may also desirable

15. 14 Stock Acquisition  Value of combined firm V AB = V A + V B +  V V AB = V A + V B +  V  Cost of acquisition Depends on the number of shares given to the target stockholders Depends on the number of shares given to the target stockholders Depends on the price of the combined firm’s stock after the merger 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 Sharing gains – target stockholders don’t participate in stock price appreciation with a cash acquisition Taxes – cash acquisitions are generally taxable Taxes – cash acquisitions are generally taxable Control – cash acquisitions do not dilute control Control – cash acquisitions do not dilute control

16. 15 Defensive Tactics  Corporate charter Establishes conditions that allow for a takeover Establishes conditions that allow for a takeover Supermajority voting requirement Supermajority voting requirement  Targeted repurchase A.K.A. greenmail  Standstill agreements  Poison pills (share rights plans)  Leveraged buyouts

17. 16 More (Colorful) Terms  Golden parachute  Poison put  Crown jewel  White knight  Lockup  Shark repellent  Bear hug  Fair price provision  Dual class capitalization  Countertender offer

18. 17 Evidence on Acquisitions  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 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 Target firm managers have a tendency to oppose mergers, thus driving up the tender price  Shareholders of bidding firms earn a small excess return in a tender offer, but none in a straight merger Anticipated gains from mergers may not be achieved 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 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 Management may not be acting in stockholders’ best interest Takeover market may be competitive Takeover market may be competitive Announcement may not contain new information about the bidding firm Announcement may not contain new information about the bidding firm

19. 18 Divestitures and Restructurings  Divestiture – company sells a piece of itself to another company  Equity carve-out – company creates a new company out of a subsidiary and then sells a minority interest to the public through an IPO  Spin-off – company creates a new company out of a subsidiary and distributes the shares of the new company to the parent company’s stockholders  Split-up – company is split into two or more companies and shares of all companies are distributed to the original firm’s shareholders