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Mergers and Acquisitions

Chapter 29

Copyri ght 2010 by the McGraw-Hi ll Companies, Inc. All ri ghts reserved.McGraw-Hill/Irwin

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Key Concepts and Skills Be able to define the various terms associated

with M&A activity

Understand the various reasons for mergersand whether or not those reasons are in the

best interest of shareholders

Understand the various methods for paying foran acquisition

Understand the various defensive tactics that

are available

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Chapter Outline29.1 The Basic Forms of Acquisitions29.2 Synergy29.3 Sources of Synergy

29.4 Two Financial Side Effects of Acquisitions29.5 A Cost to Stockholders from Reduction in Risk29.6 The NPV of a Merger29.7 Friendly versus Hostile Takeovers29.8 Defensive Tactics

29.9 Do Mergers Add Value?29.10 The Tax Forms of Acquisitions29.11 Accounting for Acquisitions29.12 Going Private and Leveraged Buyouts

29.13 Divestitures

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29.1 The Basic Forms of Acquisitions There are three basic legal procedures that

one firm can use to acquire another firm:

Merger or Consolidation Acquisition of Stock

Acquisition of Assets

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Merger versus Consolidation Merger

One firm is acquired by another

Acquiring firm retains name and acquired firmceases to exist

Advantagelegally simple

Disadvantagemust be approved by stockholders

of both firms Consolidation

Entirely new firm is created from combination ofexisting firms

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Acquisitions A firm can be acquired by another firm or individual(s)

purchasing voting shares of the firms stock

Tender offerpublic 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 moneycomplete absorption requires a merger

Classifications Horizontalboth firms are in the same industry

Verticalfirms are in different stages of the production process

Conglomeratefirms are unrelated

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Varieties of Takeovers

Takeovers

Acquisition

Proxy Contest

Going Private(LBO)

Merger

Acquisition of Stock

Acquisition of Assets

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Synergy Suppose firmAis contemplating acquiring

firmB.

The synergy from the acquisition isSynergy = VAB(VA+ VB)

The synergy of an acquisition can be

determined from the standard discounted cashflow model:

Synergy =

DCFt

(1 +R)tSt= 1

T

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29.3 Sources of Synergy Revenue Enhancement

Cost Reduction

Replacement of ineffective managers Economy of scale or scope

Tax Gains

Net operating losses

Unused debt capacity

Incremental new investment required inworking capital and fixed assets

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29.4 Two Financial Side Effects of

Acquisitions

Earnings Growth

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 (i.e., an accounting

illusion).

Diversification

Shareholders who wish to diversify can accomplishthis at much lower cost with one phone call to their

broker than can management with a takeover.

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29.5 A Cost to Stockholders from

Reduction in Risk The Base Case

If two all-equity firms merge, there is no transfer

of synergies to bondholders, but if Both Firms Have Debt

The value of the levered shareholders call option

falls.

How Can Shareholders Reduce their Losses

from the Coinsurance Effect?

Retire debt pre-merger and/or increase post-merger

debt usage.

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29.6 The NPV of a Merger

Typically, a firm would use NPV analysis

when making acquisitions.

The analysis is straightforward with a cashoffer, but it gets complicated when the

consideration is stock.

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Cash Acquisition

The NPV of a cash acquisition is:

NPV = (VB+ V)cash cost = 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 mayalso be desirable.

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Stock Acquisition Value of combined firm

VAB= VA+ VB+ DV

Cost of acquisition

Depends on the number of shares given to the targetstockholders

Depends on the price of the combined firms stock after themerger

Considerations when choosing between cash and

stock Sharing gainstarget stockholders do not participate in

stock price appreciation with a cash acquisition

Taxescash acquisitions are generally taxable

Controlcash acquisitions do not dilute control

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29.7 Friendly vs. Hostile Takeovers

In a friendly merger, both companies

management are receptive.

In a hostile merger, the acquiring firmattempts to gain control of the target without

their approval. Tender offer

Proxy fight

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29.8 Defensive Tactics

Corporate charter

Classified board (i.e., staggered elections)

Supermajority voting requirement Golden parachutes

Targeted repurchase (a.k.a. greenmail)

Standstill agreements Poison pills (share rights plans)

Leveraged buyouts

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More (Colorful) Terms

Poison put

Crown jewel

White knight

Lockup

Shark repellent

Bear hug

Fair price provision Dual class capitalization

Countertender offer

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29.9 Do Mergers Add Value?

Shareholders of target companies tend to earn excessreturns 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.

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Do Mergers Add Value?

Shareholders of bidding firms earn a small excessreturn in a tender offer, but none in a straightmerger:

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 aboutthe bidding firm.

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29.10 The Tax Forms of Acquisition

If it is a taxable acquisition, selling

shareholders need to figure their cost basis

and pay taxes on any capital gains. If it is not a taxable event, shareholders are

deemed to have exchanged their old shares for

new ones of equivalent value.

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29.11 Accounting for Acquisitions

The Purchase Method

Assets of the acquired firm are reported at their

fair market value. Any excess payment above the fair market value

is reported as goodwill.

Historically, goodwill was amortized. Now it

remains on the books until it is deemed

impaired.

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29.12 Going Private and Leveraged

Buyouts The existing management buys the firm from

the shareholders and takes it private.

If it is financed with a lot of debt, it is aleveraged buyout (LBO).

The extra debt provides a tax deduction for the

new owners, while at the same time turning thepervious managers into owners.

This reduces the agency costs of equity.

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29.13 Divestitures

Divestiturecompany sells a piece of itself toanother company

Equity carve-outcompany creates a newcompany out of a subsidiary and then sells aminority interest to the public through an IPO

Spin-offcompany creates a new company

out of a subsidiary and distributes the shares ofthe new company to the parent companysstockholders

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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 of these may be in stockholders best interest

and which generally are not?

What are some of the defensive tactics that firms useto thwart takeovers?

How can a firm restructure itself? How do these

methods differ in terms of ownership?