chapter 25-mergers & acquisitions

Excel BooksExcel BooksFINANCIAL MANAGEMENT, Dr. Sudhindra Bhat

Copyright © 2008, Dr Sudhindra Bhat

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MERGERS & ACQUISITIONS

25MERGERS & ACQUISITIONS

Chapter



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Mergers, Acquisitions, and Takeovers: What are the Differences?

Merger

A strategy through which two firms agree to integrate their operations on a

relatively co-equal basis

Acquisition

A strategy through which one firm buys a controlling, or 100% interest in

another firm with the intent of making the acquired firm a subsidiary business

within its portfolio

Takeover

A special type of acquisition when the target firm did not solicit the acquiring

firm’s bid for outright ownership



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Increased diversification

Learning and developing new

capabilities

Acquisitions

Cost new product development/increased

speed to market

Increased market power Avoiding excessive

competition

Overcoming entry barriers

Lower risk compared to developing new

products

Adapted from Figure 7.1Adapted from Figure 7.1

Reasons for Acquisitions and Problems in Achieving Success



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Market Power Acquisitions

Acquisition of a company in the same industry in

which the acquiring firm competes increases a

firm’s market power by exploiting:

Cost-based synergies

Revenue-based synergies

Acquisitions with similar characteristics result in

higher performance than those with dissimilar

characteristics

Horizontal Horizontal AcquisitionsAcquisitions



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Market Power Acquisitions (cont’d)

Acquisition of a supplier or distributor of one or

more of the firm’s goods or services

Increases a firm’s market power by controlling

additional parts of the value chain


Vertical Vertical AcquisitionsAcquisitions



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Market Power Acquisitions (cont’d)

Acquisition of a company in a highly related

industry

Because of the difficulty in implementing

synergy, related acquisitions are often

difficult to implement


Vertical Vertical AcquisitionsAcquisitions

Related Related AcquisitionsAcquisitions



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Acquisitions

Reasons for Acquisitions and Problems in Achieving Success


Integration difficulties

Inadequate evaluation of

target Large or extraordinary debt

Inability to achieve synergy

Too much diversification

Managers overly focused on acquisitions

Too large



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Problems in Achieving Acquisition Success: Integration Difficulties

Integration challenges include:

Melding two disparate corporate cultures

Linking different financial and control systems

Building effective working relationships (particularly when management styles differ)

Resolving problems regarding the status of the newly acquired firm’s executives

Loss of key personnel weakens the acquired firm’s capabilities and reduces its value



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Problems in Achieving Acquisition Success: Inadequate Evaluation of the Target

Due Diligence

The process of evaluating a target firm for acquisition

Ineffective due diligence may result in paying an excessive premium for

the target company

Evaluation requires examining:

Financing of the intended transaction

Differences in culture between the firms

Tax consequences of the transaction

Actions necessary to meld the two workforces



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Problems in Achieving Acquisition Success: Large or Extraordinary Debt

High debt can:

Increase the likelihood of bankruptcy

Lead to a downgrade of the firm’s credit rating

Preclude investment in activities that contribute to the firm’s long-term success

such as:

Research and development

Human resource training

Marketing



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Problems in Achieving Acquisition Success: Inability to Achieve Synergy

Synergy exists when assets are worth more when used in conjunction with

each other than when they are used separately

Firms experience transaction costs when they use acquisition strategies

to create synergy

Firms tend to underestimate indirect costs when evaluating a potential

acquisition



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Problems in Achieving Acquisition Success: Too Much Diversification

Diversified firms must process more information of greater diversity

Scope created by diversification may cause managers to rely too much on

financial rather than strategic controls to evaluate business units’ performances

Acquisitions may become substitutes for innovation



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Problems in Achieving Acquisition Success: Managers Overly Focused on Acquisitions

Managers invest substantial time and energy in acquisition strategies in:

Searching for viable acquisition candidates

Completing effective due-diligence processes

Preparing for negotiations

Managing the integration process after the acquisition is completed



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Problems in Achieving Acquisition Success: Managers Overly Focused on Acquisitions

Managers in target firms operate in a state of virtual suspended animation during

an acquisition

Executives may become hesitant to make decisions with long-term

consequences until negotiations have been completed

The acquisition process can create a short-term perspective and a greater aversion

to risk among executives in the target firm



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Problems in Achieving Acquisition Success: Too Large

Additional costs of controls may exceed the benefits of the economies of scale

and additional market power

Larger size may lead to more bureaucratic controls

Formalized controls often lead to relatively rigid and standardized managerial

behavior

Firm may produce less innovation



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Attributes of Successful

Acquisitions



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Restructuring and Outcomes




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Explain why a company might decide to engage in corporate restructuring.

Understand and calculate the impact on earnings and on market value of companies

involved in mergers.

Describe what benefits, if any, accrue to acquiring company shareholders and to

selling company shareholders.

Analyze a proposed merger as a capital budgeting problem.

Describe the merger process from its beginning to its conclusion.

Describe different ways to defend against an unwanted takeover.

Discuss strategic alliances and understand how outsourcing has contributed to the

formation of virtual corporations.

Explain what “divestiture” is and how it may be accomplished.

Understand what "going private" means and what factors may motivate

management to take a company private.

Explain what a leveraged buyout is and what risk it entails.



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Sources of Value

Strategic Acquisitions Involving Common Stock

Acquisitions and Capital Budgeting

Closing the Deal

Mergers and Other Forms of Corporate Restructuring



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Takeovers, Tender Offers, and Defenses

Strategic Alliances

Divestiture

Ownership Restructuring

Leveraged Buyouts

Mergers and Other Forms of Corporate Restructuring



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Any change in a company’s:

Capital structure,

Operations, or

Ownership

that is outside its ordinary course of business.

So where is the value coming

from (why restructure)?

What is Corporate Restructuring?



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Sales enhancement and operating economies*

Improved management

Information effect

Wealth transfers

Tax reasons

Leverage gains

Hubris hypothesis

Management’s personal agenda

* Will be discussed in more detail in the following two slides.

Why Engage in Corporate Restructuring?



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Sales enhancement Sales enhancement can occur because of market share gain, technological

advancements to the product table, and filling a gap in the product line.

Operating economies Operating economies can be achieved because of the elimination of duplicate

facilities or operations and personnel.

SynergySynergy -- Economies realized in a merger where the performance of the combined

firm exceeds that of its previously separate parts.

Sales Enhancement and Operating Economies



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Horizontal mergerHorizontal merger: best chance for economies

Vertical mergerVertical merger: may lead to economies

Conglomerate mergerConglomerate merger: few operating economies

DivestitureDivestiture: reverse synergy may occur

Economies of ScaleEconomies of Scale -- The benefits of size in which the average unit cost falls as

volume increases.

Sales Enhancement and Operating Economies



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When the acquisition is done for common stock, a “ratio of exchange,” which

denotes the relative weighting of the two companies with regard to certain key

variables, results.

A financial acquisition financial acquisition occurs when a buyout firm is motivated to purchase the

company (usually to sell assets, cut costs, and manage the remainder more

efficiently), but keeps it as a stand-alone entity.

Strategic Acquisition Strategic Acquisition -- Occurs when one company acquires another as part of its

overall business strategy.




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Example Example -- Company A will acquire Company B with shares of common stock.

Present earnings $20,000,000 $5,000,000

Shares outstanding 5,000,000 2,000,000

Earnings per share $4.00 $2.50

Price per share $64.00 $30.00

Price / earnings ratio 16 12

Company A Company B




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Example Example -- Company B has agreed on an offer of $35 in common stock of Company A.

Total earnings $25,000,000Shares outstanding* 6,093,750Earnings per share $4.10

Surviving Company A

Exchange ratio = $35 / $64 = .546875.546875

* New shares from exchange New shares from exchange = .546875.546875 x 2,000,000= 1,093,7501,093,750




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The shareholders of Company A will experience an increase in earnings per share

because of the acquisition [$4.10 post-merger EPS versus $4.00 pre-merger EPS].

The shareholders of Company B will experience a decrease in earnings per share

because of the acquisition [.546875 x $4.10 = $2.24 post-merger EPS versus $2.50

pre-merger EPS].




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Surviving firm EPS will increase any time the P/E ratio “paid” for a firm is less than

the pre-merger P/E ratio of the firm doing the acquiring. [Note: P/E ratio “paid” for

Company B is $35/$2.50 = 14 versus pre-merger P/E ratio of 16 for Company A.]




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Example Example -- Company B has agreed on an offer of $45 in common stock of Company A.

Total earnings $25,000,000

Shares outstanding* 6,406,250

Earnings per share $3.90

Surviving Company A

Exchange ratio = $45 / $64 = .703125.703125

* New shares from exchange New shares from exchange = .703125.703125 x 2,000,000 = 1,406,2501,406,250




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The shareholders of Company A will experience a decrease in earnings per share

because of the acquisition [$3.90 post-merger EPS versus $4.00 pre-merger EPS].

The shareholders of Company B will experience an increase in earnings per share

because of the acquisition [.703125 x $4.10 = $2.88 post-merger EPS versus $2.50

pre-merger EPS].




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Surviving firm EPS will decrease any time the P/E ratio “paid” for a firm is greater

than the pre-merger P/E ratio of the firm doing the acquiring. [Note: P/E ratio “paid”

for Company B is $45/$2.50 = 18 versus pre-merger P/E ratio of 16 for Company A.]




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Merger decisions should not be

made without considering the

long-term consequences.

The possibility of future earnings

growth may outweigh the

immediate dilution of earnings.

Initially, EPS is less with the merger.

Eventually, EPS is greater with the merger.

With theWith themergermerger

Without theWithout themergermerger

Time in the Future (years)

Exp

ecte

d E

PS

($)

Equal

What About Earnings Per Share (EPS)?



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The above formula is the ratio of exchange of market price.

If the ratio is less than or nearly equal to 1, the shareholders of the acquired firm are

not likely to have a monetary incentive to accept the merger offer from the acquiring

firm.

Market price per share of the acquiring company

Number of shares offered by the acquiring company for each share of the acquired company

Market price per share of the acquired company

X

Market Value Impact



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Example Example -- Acquiring Company offers to acquire Bought Company with shares of common stock at an exchange price of $40.

Present earnings $20,000,000 $6,000,000Shares outstanding 6,000,000 2,000,000Earnings per share $3.33 $3.00Price per share $60.00 $30.00Price / earnings ratio 18 10

Acquiring BoughtCompany Company

Market Value Impact



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Exchange ratio = $40 / $60 = .667Market price exchange ratio = $60 x .667 / $30 = 1.33

Total earnings $26,000,000

Shares outstanding* 7,333,333

Earnings per share $3.55

Price / earnings ratio 18

Market price per share $63.90

Surviving Company

* New shares from exchange = .666667 x 2,000,000 = 1,333,333

Market Value Impact



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Notice that both earnings per share and market price per share have risen because

of the acquisition. This is known as “bootstrapping.”

The market price per share = (P/E) x (Earnings).

Therefore, the increase in the market price per share is a function of an expected

increase in earnings per share and the P/E ratio NOT declining.

The apparent increase in the market price is driven by the assumption that the P/E

ratio will not change and that each dollar of earnings from the acquired firm will be

priced the same as the acquiring firm before the acquisition (a P/E ratio of 18).

Market Value Impact



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Target firms in a takeover

receive an average premium

of 30%.

Evidence on buying firms is

mixed. It is not clear that

acquiring firm shareholders

gain. Some mergers do have

synergistic benefits.

Buyingcompanies

Sellingcompanies

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Announcement date

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Empirical Evidence on Mergers



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Idea is to rapidly build a larger and more valuable firm with the acquisition of small- and

medium-sized firms (economies of scale).

Provide sellers cash, stock, or cash and stock.

Owners of small firms likely stay on as managers.

If privately owned, a way to more rapidly grow towards going through an initial public

offering (see Slide 22).

Roll-Up Transactions – The combining of multiple small companies in the same industry

to create one larger company.

Developments in Mergers and Acquisitions



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IPO funds are used to finance the acquisitions.

IPO Roll-Up IPO Roll-Up – An IPO of independent companies in the same industry that merge into a

single company concurrent with the stock offering.

An Initial Public Offering (IPO) is a company’s first offering of common stock to the

general public.

Developments in Mergers and Acquisitions



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An acquisition can be treated as a capital budgeting project. This requires an

analysis of the free cash flowsfree cash flows of the prospective acquisition.

Free cash flowsFree cash flows are the cash flows that remain after we subtract from expected

revenues any expected operating costs and the capital expenditures necessary to

sustain, and hopefully improve, the cash flows.

Free cash flowsFree cash flows should consider any synergistic effects but be before any financial

charges so that examination is made of marginal after-tax operating cash flows and

net investment effects.

Acquisitions and Capital Budgeting



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AVERAGE FOR YEARS (in thousands) 1 - 5 6 - 10 11 - 15

Annual after-tax operating cash flows from acquisition $2,000 $1,800 $1,400

Net investment 600 300 ---

Cash flow after taxes $1,400 $1,500 $1,400

16 - 20 21 - 25Annual after-tax operating cash flows from acquisition $ 800 $ 200

Net investment --- ---

Cash flow after taxes $ 800 $ 200

Cash Acquisition and Capital Budgeting Example



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The appropriate discount rate for our example free cash flows free cash flows is the cost of capital

for the acquired firm. Assume that this rate is 15% after taxes.

The resulting present value of free cash flow free cash flow is $8,724,000$8,724,000. This represents the

maximum acquisition price that the acquiring firm should be willing to pay, if we do

not assume the acquired firm’s liabilities.

If the acquisition price is less than (exceeds) the present value of $8,724,000$8,724,000, then

the acquisition is expected to enhance (reduce) shareholder wealth over the long

run.

Cash Acquisition and Capital Budgeting Example



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Noncash payments and assumption of liabilitiesNoncash payments and assumption of liabilities

Estimating cash flowsEstimating cash flows

Cash-flow approach versus earnings per share (EPS) approachCash-flow approach versus earnings per share (EPS) approach

Generally, the EPS approach examines the acquisition on a short-run basis,

while the cash-flow approach takes a more long-run view.

Other Acquisition and Capital Budgeting Issues



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Target is evaluated by the acquirer

Terms are agreed upon

Ratified by the respective boards

Approved by a majority (usually two-thirds) of shareholders from both firms

Appropriate filing of paperwork

Possible consideration by The Antitrust Division of the Department of Justice or the

Federal Trade Commission

Consolidation -- The combination of two or more firms into an entirely new firm. The old

firms cease to exist.

Closing the Deal



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Taxable -- if payment is made by cash or with a debt instrument.

Tax-Free -- if payment made with voting preferred or common stock and the

transaction has a “business purpose.” (Note: to be a tax-free transaction a few

more technical requirements must be met that depend on whether the purchase is

for assets or the common stock of the acquired firm.)

At the time of acquisition, for the selling firm or its shareholders, the transaction is:

Taxable or Tax-Free Transaction



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Pooling of Interests (method) -- A method of accounting treatment for a merger based

on the net book value of the acquired company’s assets. The balance sheets of the two

companies were simply combined.

Purchase (method) -- A method of accounting treatment for a merger based on the

market price paid for the acquired company.

Accounting Treatments



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AS eliminated mandatory periodic amortization of goodwill for financial accounting

purposes, but requires an impairment test (at least annually) to goodwill.

Goodwill charges are generally deductible for “tax purposes” over 15 years for

acquisitions occurring after August 10, 1993.

An impairment to earnings is recognized when the book value of goodwill exceeds

its market value by an amount that equals the difference.

Goodwill -- The intangible assets of the acquired firm arising from the acquiring firm

paying more for them than their book value.

Accounting Treatment of Goodwill



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Allows the acquiring company to bypass the management of the company it wishes

to acquire.

Tender Offer -- An offer to buy current shareholders’ stock at a specified price, often with

the objective of gaining control of the company. The offer is often made by another

company and usually for more than the present market price.

Tender Offers



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It is not possible to surprise another company with its acquisition because the SEC

requires extensive disclosure.

The tender offer is usually communicated through financial newspapers and direct

mailings if shareholder lists can be obtained in a timely manner.

A two-tier offer (next slide) may be made with the first tier receiving more favorable

terms. This reduces the free-rider problem.

Tender Offers



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Two-Tier Tender Offer

Increases the likelihood of success in gaining control of the target firm.

Benefits those who tender “early.”

Two-tier Tender Offer – Occurs when the bidder offers a superior first-tier price (e.g.,

higher amount or all cash) for a specified maximum number (or percent) of shares and

simultaneously offers to acquire the remaining shares at a second-tier price.



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The company being bid for may use a number of defensive tactics including:

(1) persuasion by management that the offer is not in their best interests,

(2) taking legal actions,

(3) increasing the cash dividend or declaring a stock split to gain shareholder

support, and

(4) as a last resort, looking for a “friendly” company (i.e., white knight) to purchase

them.

White Knight -- A friendly acquirer who, at the invitation of a target company, purchases

shares from the hostile bidder(s) or launches a friendly counter-bid in order to frustrate the

initial, unfriendly bidder(s).

Defensive Tactics



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Shareholders’ Interest Hypothesis

This theory implies that contests for corporate control are dysfunctional and take

management time away from profit-making activities.

Managerial Entrenchment Hypothesis

This theory suggests that barriers are erected to protect management jobs and that such

actions work to the detriment of shareholders.

Motivation TheoriesMotivation Theories::

Antitakeover Amendments and Other Devices



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Stagger the terms of the board of directors

Change the state of incorporation

Supermajority merger approval provision

Fair merger price provision

Leveraged recapitalization

Poison pill

Standstill agreement

Premium buy-back offer

Shark Repellent -- Defenses employed by a company to ward off potential takeover

bidders -- the “sharks.”

Antitakeover Amendments and Other Devices



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Empirical results are mixed in determining if antitakeover devices are in the best

interests of shareholders.

Standstill agreements and stock repurchases by a company from the owner of a

large block of stocks (i.e., greenmail) appears to have a negative effect on

shareholder wealth.

For the most part, empirical evidence supports the management entrenchment management entrenchment

hypothesishypothesis because of the negative share price effect.

Empirical Evidence on Antitakeover Devices



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Strategic alliances usually occur between (1) suppliers and their customers, (2)

competitors in the same business, (3) non-competitors with complementary

strengths.

A joint venture joint venture is a business jointly owned and controlled by two or more independent

firms. Each venture partner continues to exist as a separate firm, and the joint

venture represents a new business enterprise.

Strategic Alliance -- An agreement between two or more independent firms to cooperate

in order to achieve some specific commercial objective.

Strategic Alliance



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Divestiture

Liquidation -- The sale of assets of a firm, either voluntarily or in bankruptcy.

Sell-off -- The sale of a division of a company, known as a partial sell-off, or

the company as a whole, known as a voluntary liquidation.

Divestiture -- The divestment of a portion of the enterprise or the firm as a whole.



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Spin-off -- A form of divestiture resulting in a subsidiary or division becoming an

independent company. Ordinarily, shares in the new company are distributed to

the parent company’s shareholders on a pro rata basis.

Equity Carve-out -- The public sale of stock in a subsidiary in which the parent

usually retains majority control.

Divestiture



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• For liquidation of the entire company, shareholders of the liquidating company realize

a +12 to +20% return.

• For partial sell-offs, shareholders selling the company realize a slight return (+2%).

Shareholders buying also experience a slight gain.

• Shareholders gain around 5% for spin-offs.

• Shareholders receive a modest +2% return for equity carve-outs.

• Divestiture results are consistent with the informational effect as shown by the positive

market responses to the divestiture announcements.

Empirical Evidence on Divestitures



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The most common transaction is paying shareholders cash and merging the company

into a shell corporation owned by a private investor management group.

Treated as an asset sale rather than a merger.

Going Private -- Making a public company private through the repurchase of stock by

current management and/or outside private investors.




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Motivation and Empirical Evidence for Going Private

Elimination of costs associated with being a publicly held firm (e.g., registration, servicing

of shareholders, and legal and administrative costs related to SEC regulations and

reports).

Reduces the focus of management on short-term numbers to long-term wealth building.

Allows the realignment and improvement of management incentives to enhance wealth

building by directly linking compensation to performance without having to answer to the

public.

MotivationsMotivations::



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Motivation and Empirical Evidence for Going Private

Large transaction costs to investment bankers.

Little liquidity to its owners.

A large portion of management wealth is tied up in a single investment.

Empirical Evidence:

Shareholders realize gains (+12 to +22%) for cash offers in these transactions.

Motivations (Offsetting Arguments):



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The debt is secured by the assets of the enterprise involved. Thus, this method is

generally used with capital-intensive businesses.

A management buyout is an LBO in which the pre-buyout management ends up with

a substantial equity position.

Leverage Buyout (LBO) -- A primarily debt financed purchase of all the stock or assets

of a company, subsidiary, or division by an investor group.




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The company has gone through a program of heavy capital expenditures (i.e.,

modern plant).

There are subsidiary assets that can be sold without adversely impacting the core

business, and the proceeds can be used to service the debt burden.

Stable and predictable cash flows.

A proven and established market position.

Less cyclical product sales.

Experienced and quality management.

Common characteristics (not all necessary):

chapter 25-mergers & acquisitions

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dr sudhindra bhat

mergers acquisitions

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mergers acquisitions

merger mergers acquisitions

financial management

large acquisitions managers