1. Mergers and Acquisitions
Chapter 26
Mergers and Acquisitions
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline The Legal Forms of Acquisition Taxes and Acquisitions
Gains from Acquisitions
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition

3. Chapter Outline (Continued)
Defensive Tactics
Some Evidence on Acquisitions: Do M & A’s Pay?
Divestitures and Restructurings

4. Chapter Outline The Legal Forms of Acquisition Taxes and Acquisitions
Gains from Acquisitions
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition

5. Merger versus Consolidation
One firm is acquired by another
Acquiring firm retains name and acquired firm ceases to exist

6. Merger versus Consolidation
Advantage – legally simple
Disadvantage – must be approved by stockholders of both firms

7. Merger versus Consolidation
Entirely new firm is created from combination of existing firms

8. Acquisitions
A firm can be acquired when another firm or individual(s) purchases voting shares of the firm’s stock
Tender offer is a public offer to buy shares on the market.

9. Acquisitions No stockholder vote required
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

10. Acquisitions Horizontal – both firms are in the same industry
Classifications:
Horizontal – both firms are in the same industry
Vertical – firms are in different stages of the production process
Conglomerate – firms are unrelated

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

12. Chapter Outline The Legal Forms of Acquisition Taxes and Acquisitions
Gains from Acquisitions
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition

13. Taxes Firm purchased with cash
Taxable acquisition
Firm purchased with cash
Capital gains taxes – stockholders of target may require a higher price to cover the taxes
Assets are revalued – affects depreciation expense

14. Taxes Business purpose; not solely to avoid taxes
Tax-free acquisition
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
Generally, stock for stock acquisition

15. Chapter Outline The Legal Forms of Acquisition Taxes and Acquisitions
Gains from Acquisitions
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition

16. Accounting for Acquisitions
Pooling of interests accounting is
no longer allowed.
Purchase Accounting
Assets of acquired firm must be reported at the fair market value.

17. Accounting for Acquisitions
Purchase Accounting
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

18. Chapter Outline The Legal Forms of Acquisition Taxes and Acquisitions
Gains from Acquisitions
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition

19. 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

20. Synergy This is generally a good reason for a merger
Examine whether the synergies create enough benefit to justify the cost

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

22. Cost Reductions Economies of scale Economies of vertical integration
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

23. Taxes Carry-backs and carry- forwards
Take advantage of net operating losses
Carry-backs and carry- forwards
Merger may be prevented if the IRS believes the sole purpose is to avoid taxes

24. Taxes Unused debt capacity Surplus funds Asset write-ups Pay dividends
Repurchase shares
Buy another firm
Asset write-ups

25. 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 reducing human capital as well)

26. 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

27. EPS Growth There is no free lunch!
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!

28. 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

29. Diversification
Stockholder wealth may actually decrease after the merger because the reduction in risk, in effect, transfers wealth from the stockholders to the bondholders

30. Chapter Outline The Legal Forms of Acquisition Taxes and Acquisitions
Gains from Acquisitions
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition

31. VAB = VA + (VB* - cash cost)
Cash Acquisition
The NPV of a cash acquisition 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 not undesirable

32. Stock Acquisition VAB = VA + VB + V Value of combined firm:
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

33. Stock vs. Cash Acquisition
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

34. Chapter Outline (Continued)
Defensive Tactics
Some Evidence on Acquisitions: Do M & A’s Pay?
Divestitures and Restructurings

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

36. More (Colorful) Terms Golden parachute Poison put Crown jewel
White knight
Lockup
Shark repellent
Bear hug
Fair price provision
Dual class capitalization
Counter-tender offer

37. Chapter Outline (Continued)
Defensive Tactics
Some Evidence on Acquisitions: Do M & A’s Pay?
Divestitures and Restructurings

38. Evidence on Acquisitions I
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

39. Evidence on Acquisitions II
Shareholders of bidding firms, on average, do not earn or lose a large amount
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

40. Evidence on Acquisitions III
Shareholders of bidding firms, on average, do not earn or lose a large amount
Management may not be acting in stockholders’ best interest
Takeover market may be competitive
Announcement may not contain new information about the bidding firm

41. Chapter Outline (Continued)
Defensive Tactics
Some Evidence on Acquisitions: Do M & A’s Pay?
Divestitures and Restructurings

42. 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

43. Divestitures and Restructurings
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

44. Ethics Issues
In the case of takeover bids, insider trading is argued to be particularly endemic because of the large potential profits involved and because of the relatively large number of people “in on the secret.”
What are the legal and ethical implications of trading on such information?
Does it depend on who knows the information?

45. 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?
How can a firm restructure itself? How do these methods differ in terms of ownership?

46. Comprehensive Problem
Two identical firms have yearly after-tax cash flows of $20 million each, which are expected to continue into perpetuity. If the firms merged, the after-tax cash flow of the combined firm would be $42 million. Assume a cost of capital of 12%.
Does the merger generate synergy?
What is VB*?
What is ΔV?

47. Terminology Merger Consolidation Acquisition Takeover Synergy
Diversification
Defensive Tactics
Divestiture
Restructuring

48. VAB = VA + (VB* - cash cost)
Formulas
NPV = VB* – cash cost
VAB = VA + (VB* - cash cost)
VAB = VA + VB + V

49. Key Concepts and Skills
Define the terminology
used in mergers and
acquisitions.
Explain the reasons for mergers and critique their value to the shareholders.
Describe the methods to pay for an acquisition.

50. Key Concepts and Skills
List and discuss the
various defensive
tactics firms can use to
prevent a takeover.
Compute the value of a
merger or acquisition.

51. What are the most important topics of this chapter?
The merging of two firms can be done in a friendly or unfriendly environment.
2. Mergers have tax, funding, accounting, and control implications for the shareholders of both companies.

52. What are the most important topics of this chapter?
Synergy can be a valuable motivation for firms to merge.
Unfriendly merger attempts can be thwarted with numerous strategies.
Merger values can be computed and evaluated as a capital budgeting problem.

53. Questions?