University of Applied Sciences Worms

Faculty of Business Administration

BACHELOR THESIS

Submitted in support of the International Management

Bachelor of Arts degree

TOPIC:

Mergers and Acquisitions: An Economic Analysis

Author: Petar Murginski

Supervisor: Prof. Dr. Dirk Schilling

Germany

-2016-

Mergers and Acquisitions:

An Economic Analysis

Attestation

This document is written by student Petar Murginski, matriculation number 670995,

who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no

sources other than those mentioned in the text and its references have been used in

creating it.

The University of Applied Sciences Worms is responsible solely for the supervision

of completion of the work, not for the contents.

Contents

1 Introduction ........................................................................................................................ 1

2 Background and Historical Trends: Merger Waves.......................................................... 2

3 The Basic Types and Forms of M&A ................................................................................ 6

3.1 Merger or Consolidation ..…………………………………………………………….. 6

3.2 Acquisitions of Shares ..………………………………………………………………. 7

3.3 Acquisition of Assets ..………………………………………………………………... 8

3.4 A Classification Scheme ……………………………………………………………… 8

3.5 Varieties of Takeover .................................................................................................... 10

4 Motives for Mergers and Reasons to Acquire ................................................................. 11

4.1 Economies of Scale and Scope ...................................................................................... 12

4.2 Economies of Vertical Integration …………………………………………………... 14

4.3 Complementary Resources, Expertise and Technology Transfer …………………… 15

4.4 Surplus Funds ……………………………………………………………………….. 16

4.5 Industry Consolidation and Monopoly Gains ……………………………………….. 17

4.6 Eliminating Inefficiences ……………………………………………………………. 17

4.7 Tax Gains from Net Operating Losses .......................................................................... 18

4.8 Diversification ………………………………………………………………………. 18

4.8.1 Risk reduction ......................................................................................................... 18

4.8.2 Debt capacity .......................................................................................................... 19

4.8.3 Liquidity .................................................................................................................. 20

4.9 Increasing Earnings and Lower Financing Costs .......................................................... 20

4.10 Managerial Motives to Merge ..................................................................................... 22

5 The Valuation, The Offer and The Deal Structuring of a Merger .................................. 23

5.1 The Net Present Value of a Merger - Gains and Costs ……………………………... 24

5.2 Right and Wrong Ways to Estimate Benefits ……………………………………….. 26

5.3 Valuation of the Synergies …………………………………………………………... 28

5.4 Stock-Financed Merger and Asymmetric Information – Cash versus Stock ................ 28

5.5 Merger Arbitrage.……………………………………………………………………. 29

6 The Mechanics of a Merger and Post-Integration Issues ................................................ 31

6.1 Mergers, Antitrust Law and Popular Opposition …………………………………… 31

6.1.1 European Commission ............................................................................................ 32

6.1.2 U. S. Department of Justice and Federal Trade Commission ................................. 32

6.2 The Form of Acquisition ………………………………………………………….... 33

6.3 Merger Accounting and Tax Issues ………………………………………………… 34

7 Do Mergers Add Value and Generate Net Benefits – Who Gets them? ......................... 36

7.1 Do Mergers Add Value and Generate Net Benefits? .................................................... 37

7.1.1 A Study of M&A Research Centre at London Business School ……………….. 37

7.1.2 The Managers versus The Shareholders ………………………………………... 39

7.2 Who Gets the Value Added from a Takeover? ............................................................. 40

7.2.1 A Note About Leveraged Buyout ........................................................................... 41

7.2.2 The Freeze-out Merger ........................................................................................... 41

7.2.3 Competition ............................................................................................................ 42

8 Conclusion ....................................................................................................................... 43

9 Bibliography .................................................................................................................... 44

*The content and structure of the Thesis is based primarily on a mixture of the following

three Corporate Finance books:

1. Brealey, Myers & Allen – ‘Corporate Finance’ 8th Edition, McGraw-Hill Publishing, 2006

2. Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Edition, Pearson Education, UK, 2011

3. Hiller, D. & Ross, S. – ‘Corporate Finance’, EU Edition, McGraw-Hill Publishing, 2013

*All of the sources mentioned in the text and the references used, were accessed

from October 1, 2015 to December 30, 2015.

1

1 Introduction

Mergers and acquisitions (M&A) are a big part of the finance world. They are major

events of the corporate sector. The process of mergers and acquisitions plays a decisive role

in influencing the trends of the global financial market. In the process, two or more separate

companies are united and a major company is formed. These corporate deals may cost large

amount of money. Sometimes the investment banks are related to the process of merger and

acquisitions. Every day, Wall Street investment bankers arrange M&A transactions, which

bring separate companies together to form larger ones.

Not surprisingly, these actions often appear in the news. Deals can be worth hundreds of

millions, or even billions of dollars. They can dictate the fortunes of the companies involved

for years to come. For a CEO, leading an M&A can represent the highlight of a whole

career.1 Sure, M&A deals grab headlines, but what does this all mean to investors?

To answer this question, this dissertation includes some historical background about the

market for mergers and acquisitions, the basic types and forms of M&A, the motives that

drive companies to acquire or merge with others. Then we review the takeover process itself

and estimate the gains and costs. Next we discuss the mechanics of a merger and potential

post-integration issues. Finally, we address the question of who benefits from the value that

is added when a takeover occurs.

Once we know the different ways in which these deals are executed, we will get a more

transparent image of the takeover process.

1 http://www.investopedia.com/university/mergers/ - The Official Website of Investopedia, an online site for investing education.

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2 Background and Historical Trends:

Merger Waves

For several decades, mergers and acquisitions have become like a science to

corporations, in terms of buying and selling of firms where one of the participants acquires

the other, respectively the buyer becomes bidder, and the seller is the target firm. Ownership

and control of a company can be changed by either acquiring or merging, but in both

processes of a takeover, some of the following two mechanisms must be accomplished. The

stock and the assets have to be purchased for cash, or something equivalent, such as new

shares in the potential freshly formed company. Usually the first mechanism is preferred by

the target firm, and the second – by the acquirer, due to complex reasons which are going to

be analyzed. Mergers and acquisitions represent a large part of what is known as the

corporate control market.2 They are very popular strategy for the companies which seek a

rapid growth and diversification; or simply just driven by a desire for power and/or

becoming larger.

According to the size of the deals and the numbers of transactions for the last 20 years, M&A

activity has reached its highest point. The global takeover market is highly active with

transaction value of more than $1 trillion average per year.3 Table 1 lists the twenty largest

transactions completed during the ten-year period from the beginning of the century. As the

2 Berk, J., DeMarzo, P. – ‘Corporate Finance’, 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 891 3 Mendenhall, Stahl - ‘Mergers and Acquisitions’, Stanford Business Book, California (2005), p. 3

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table indicates, takeovers happen between popular companies, and those transactions can

involve large sums of money.

Table 1. Twenty Largest Merger Transactions, 2000-2010 4

The mergers and acquisitions’ history represent us that the worldwide volume of takeovers

remains at a highest level, even though this unknown wave of M&A has drop in the

beginning of the century as the global economy settled down and went into recession after

the dot-com bubble. The largest deal happened the previous year, in 1999, where the acquirer

4 Institute of Mergers, Acquisitions, and Alliances – http://www.imaa-institute.org/statistics-mergers-acquisitions.html#TopMergersAcquisitions_Worldwide for Table 1 and Figure 1

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was Vodafone AirTouch PLC and the target – Mannesmann AG, for a record value of $202.8

bn. The majority of business observers believe that M&A trend is progressive and the

activity is going to increase even more, so in the long term we should not be surprised by the

implementation of more frequent and larger deals.

Despite the popularity and strategic importance, most of the takeovers did not work. On the

other hand, many bidders have been very successful of managing the acquisitions and in the

integration process. Still the performance of companies is quite subjective, especially the

cross-border mergers, where many external factors are involved, from the sociocultural to the

management approach.

Another possibility to describe the takeover market is by Merger Waves.

Takeovers may result from mistakes in valuation by the stock market. Sometimes the

acquiring firm could think that the value of the target firm is underestimated by the investors,

and/or they will count on deceiving the investor’s assessment and market reaction, hoping

that the value of the combined firm will be overestimated.5 Merger activity is greater during

economic expansions, a period when business activity arise and GDP expands until it reaches

a peak. An expansion is one of the two basic business cycle phases. The other is contraction.

‘Peak’ is the transition from expansion to contraction and the change from contraction to

expansion is a trough. Thus, the same economic activities that drive expansions most likely

also drive peaks in merger activity. Figure 1 describes the takeover activity from 1985 to

2014.

5 Brealey, Myers & Allen – ‘Corporate Finance’, 8th Int. Edition, McGraw-Hill Publishing (2006); Ch. 32 / p. 875

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Figure 1. Announced M&A6

Figure 1 shows that periods of the greatest takeover activity occurred in the last 20 years

between the 1990s and 2000s. Each merger wave was described by a typical type of deal:7

In the earlier 1960s there was an increase activity of firms which acquired others in unrelated

business, also known as ‘the conglomerate wave’. Next was the era of the unfriendly

mergers, where the bidder bought a bad-performing conglomerate and sold its individual

business price for more than they acquired it - those hostile takeovers were typical for the

1980s. By contrast, the 1990s, were known for its global or strategic deals which were more

likely to be friendly, rather than hostile, and to involve companies in related businesses, not

such from unrelated or conglomerate business. They were designed to create huge economies

of scale, so that they are able to gain competitive advantages and operate globally. The next

jump in the takeover activity began 10 years ago. 2004 was characterized by consolidation in

6 See Reference 4 7 Berk, J., DeMarzo, P. – ‘Corporate Finance’, 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 892

6

many industries such as IT/Software and telecommunications. The world financial crisis in

2008 brought a sudden end to the latest merger wave as the trend since then is almost the

same, without any significant fluctuations.

3 The Basic Types and Forms of M&A

The basic types of mergers and form of acquisitions contain various types of

transactions, depending on the relation between the companies involved, and the payment

method used in the deal.8 The quintessence of the process is to select them, and to find a

significant and meaningful synergy between the companies.

3.1 Mergers or Consolidation

According to the terminology, a merger exists where two or more than two firms are

combining together their liabilities and assets, so that the result is a new firm, under the

identity of one of the firms.9 Usually this is the larger firm, thus the target firm stops to exist

as a separate unit. Although there are mergers of equals (MOE), another subtype. Yet, it is

supposed a brighter contrast to exist, but still one of the companies is “more equal” than the

other (the most typical example is the Daimler-Chrysler MOE in 1998). Those kind of

mergers of similar size-firms almost never work as they are very challenging from

communications perspective. Actually, the practice shows that it is because of the differences

8 Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 893 9 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 784

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between the internal politics and the fact that nobody believes that such a thing really exists.

Both companies are equal until the contract is signed, therefore it is used more because of

psychological reasons and shareholders mind game, in order to complete the deal.

By contrast, consolidation is similar, where the combination of at least two companies form a

completely new corporation. It is quite the same as a merger, the only difference is that a

new firm is created and both companies end their previous legal existence.10 However, the

process must be approved by the shareholders of both companies, otherwise expensive legal

proceedings could occur, if they cannot agree about the conditions of the deal.

3.2 Acquisitions of Shares

Another type of acquisition is to purchase the firm’s shares in exchange of some of the two

mechanisms mentioned above – cash, or shares of equity and other securities. For this kind

of type, the process is possible to start as a private offer by the management of one firm to

another. The other possibility is to take the offer straight to the target firm’s shareholders by

a tender offer, which is a public offer where the bidder reveals his intensions to purchase

shares of the target. It is communicated to the acquired firm’s shareholders by an

announcements, typically through newspaper advertisement. Sometimes is used a general

mailing, which usually is difficult, because the names and addresses of the shareholders are

often not available. However, there are several different factors, which are involved in

choosing between mergers and acquisitions of shares. In an acquisition of shares

shareholders do not necessary need to arrange meetings or to vote. The acquiring firm can

avoid the target’s board of directors and management, and to contact its shareholders via a

10 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 785

8

tender offer, but if they are not interested in the offer, they can simply decline it, so that they

do not need to tender their shares. It is typical for the target managers to resist acquisition as

they are threatened of losing their own and their colleagues’ job. That is the reason why the

acquirer wants to find a way around and tender offer is the most appropriate tool. Because of

that defense and refusal to accept bidder’s offer, the cost of the potential acquisitions by

shares becomes higher than the potential cost by mergers. In contrast, frequently a minority

of shareholders will resist in a tender offer, so that the target firm cannot be fully taken.

Therefore, a merger is required in order to have a complete absorption, and this is why at the

end many acquisitions of shares become formal mergers.11

3.3 Acquisitions of Assets

One company can acquire another by buying all of its assets, if the shareholders approve the

deal through voting. The largest benefit in acquisition of assets compared to the acquisition

of shares is that the acquirer is not left with minority shareholders, but still, includes

transferring ownership to particular assets, which can be very expensive.12

3.4 A Classification Scheme

Financial analysts have classified acquisitions into four types:13

Horizontal Acquisitions is when one firm acquires another firm in the same industry. The

potential benefits, which can be expected from the horizontal type of acquisition are:

economies of scale in production and distribution, and possible increases of market power in

11 See Reference 10 (for References 11 and 12). 13 Gitman, L. & Zutter, C. – ‘Principles of Managerial Finance’ 13th Global Edition, Pearson Education, England (2012); Ch. 18 / p. 720

9

a more concentrated industry, or geographic territory. If a significant percentage of

competition is reduced, the acquisitions could be interpret as creating a monopoly which will

cause antitrust legislation issues.

Vertical Acquisitions gives the opportunity for own supply chain to be integrated, which can

lead to efficiencies improvement and costs savings. This could happen when both the

acquiring and the target companies are in industries with strong supplier-buyer relationships

and the acquired firm is either one of them to the acquiring firm. Acquisition of suppliers

could provide a secure access to materials at any time. In that way levels of demand, and

respectively, market share could be increased, not to mention that the same supplies which

are controlled, can be and usually are important to the competition as well.

Concentric acquisitions are firms which are involved in similar types of business. The

acquirer and target firms can be related through production processes, technologies, or

markets. Benefits could be gained from economies of scale and from entry into a related

market, which will lead to higher returns to the acquirer. The target firm represents an

extension of an existing unit mentioned above, if not all.

Conglomerate acquisitions is an acquisition between firms that are involved in totally

unrelated businesses. They are divided into two types – pure conglomerate, where

acquisitions involve firms of nothing in common, and mixed conglomerate acquisitions,

which involve businesses that are looking for potential product or market extension. The

matter is how the acquired entity can improve the overall performance and generation of

resources.14 15

14 Brealey, Myers & Allen – ‘Corporate Finance’, 8th Int. Edition, McGraw-Hill Publishing (2006); Ch. 32 / p. 871 15 Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p.893

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3.5 Varieties of Takeover

Takeover is a general and not exact term regarding the transfer of ownership and control of a

company from one group of shareholders to another. Takeovers include a wider range of

activities as they can occur by acquisition, proxy contests and going-private transactions:

If a takeover is achieved by acquisition, it will be by merger, tender offer for shares of

equity, or purchase of assets.

Proxy contests can result in takeovers as well. In proxy fights, the acquirer is trying to

persuade as many existing shareholders as possible to vote against the current management,

so that it becomes easier for the deal to succeed.

In going-private transactions a small group of investors purchases all the equity shares of a

public firm. The group usually includes members of the current management and external

investors.16

In conclusion, deals also vary based on the method of payment, whether the target

shareholders receive stock or cash for the shares of their company. The common practice is

the target shareholders to receive stock, cash, or mix of both.

16 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 786

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4 Motives for Mergers and Reasons to Acquire

Companies sometimes use mergers to expand by acquiring control of another

company. The motives for a takeover should be the potential synergies which improve the

firm’s share value, economies of scale, scope or vertical integration, complementary

resources, expertise, technology transfer, the use of the surplus funds and other reasons such

as tax considerations, diversification in terms of risk reduction, debt capacity and lower

financing costs, and increasing liquidity, which are going to be discussed next.

The rational reason for M&A, and some large strategic investments are often explained with

a creation of synergy. This is the additional value that is created by combining two firms,

generating such opportunities that would not been available to these firms operating

independently, without outside support or influence in terms of control. Synergy is what

allows acquirers to pay billions of dollars in premiums in acquisitions. By far, no doubt, this

is the most common explanation that bidders give for the premium they pay for acquiring a

target.

The potential sources of synergy could be categorized in several groups:

Operating synergies affect the operations of the combined firm and include economies of

scale, vertical integration, expertise, and higher growth potential. They generally come up as

cash flows with higher expectations. In vertical integration, combining firms at different

stages of an industry may achieve more efficient coordination of the different levels, because

12

the communication costs, the different forms of bargaining, and the resistant behavior can be

avoided. 17

Financial synergies, on the other hand, are more focused and include tax benefits,

diversification, a higher debt capacity and usage of surplus cash. They sometimes show up as

higher cash flows and sometimes take the form of lower discount rates. Possible financial

synergies involve some unsolved issues of finance theory as well. Nevertheless, empirical

analysis of mergers can help solving the main issues. As a result of a merger, the cost of

capital function may be lowered. The losses and costs may be solid if the cash flow streams

of the two companies are not matching each other.18

Last but not least, there are other motives for a merger besides synergy, as the managers are

likely to view at a potential takeover differently.

4.1 Economies of Scale and Scope

Economies of scale is the decreasing of production costs that the firm is achieving per unit

product in result of increasing scale of output, which means that the average cost of

production falls as the level of production increases. Large companies could achieve

economies of scale by producing goods in high volume that smaller companies could not

afford. This is another reason why managers believe that their own firm would be more

competitive if they are bigger. Figure 2 on the next page illustrates the relation between cost

per unit and size for a typical firm.19

17 See Damodaran, A. – ‘The Value of Synergy’, NYU Stern School of Business, USA (2005), p. 3 - http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf 18 Rock, Milton L. – ‘The Mergers and Acquisitions Handbook’, McGraw-Hill Book Company (1987); Ch.3 / p. 35 19 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 789

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Figure 2. Economies of scale and the optimal size of the firm (Source: Hiller & Ross, ibid ref. 19)

On Figure 2 is shown that the average cost first falls and then rises, as there is a limit to the

expansion of an organization. It can grow only to a certain period. After reaching that

particular moment, it becomes very expensive to manage such a big organization for a

number of reasons. It becomes complicated and the output is no longer efficient. This

moment is known as "diseconomies of scale"20. On the other hand, economies of scale are

essential benefit of horizontal and conglomerate mergers due to some financial managers,

who can see potential economies of scale in almost any industry, which is quite optimistic. It

is that way, because to buy a good-performing business is always easier, rather than to

integrate it with existing yours on a later stage.

Larger firms can also benefit from economies of scope, which are done through diversity, not

volume increasing. Economies of scope include lowering the average costs per unit by

producing more products. They are more flexible in product design and possess better

20 See http://www.investopedia.com/terms/d/diseconomiesofscale.asp - Diseconomies of Scale definition

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control of the processes. Another business advantage that economies of scope have is the

reduced cost from less waste, and less risk in terms of product line in different countries in

some industries.21

There may be also costs associated with size as larger firms are more difficult to manage

than smaller. In a small firm, the manager is often closer to the operation, the communication

is better and is supposed to have a more transparent perspective as he or she is in contact

with the most important people, and keeps track of every potential issue. They receive

information faster, so that the smaller the company is, the better ability to react in a potential

quick change in the economic environment is achieved.

4.2 Economies of Vertical Integration

Operating economies can be gained from both vertical and horizontal combinations. The

main purpose of vertical acquisitions is to improve closely related businesses or units.

Vertical integration refers to the merger of two companies in the same industry that make

products, needed at different stages of the production cycle.22

Companies believe they can increase their production if they have direct control of the

materials required to make the product. Another reason, if the company is not satisfied by the

way its products are distributed, they can decide to take control of the distributions channels.

The main benefit of vertical integration is coordination. Management can be sure that the

companies are working toward the same goal only by putting them under control and same

governance. 23 However, the larger the company is, the more difficult it is to run it.

21 See vid. http://www.investopedia.com/terms/e/economiesofscope.asp - Economies of Scale v. Scope 22 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 788 23 Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 895

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4.3 Complementary Resources, Expertise and Technological Transfer

The target company may have resources, expertise or technology that the acquiring

company needs to improve according to its performance, revenue, productivity and costs.

Thus, some of them or a mix, can become a motive for merger.

The targets are desired by the acquirers usually because they can perform better those

particular operations, in which they are specialized as they can improve the usage of the

already existing resources and even to supply the absent components.24 This increases the

firm’s productivity and value, so it make sense for companies to merge if each has what the

other needs, and in many cases it is impossible to be competitive, if separated.

In order to compete more efficiently, companies need expertise in particular areas to gain

competitive advantages. Hiring people with experience and skill is not always the best

solution, as their expertise could be old-fashioned and unappropriated, or even time-wasting

in terms of using new technology which is unfamiliar and difficult to run. A more efficient

solution is to purchase the talent as an already functioning unit by acquiring an existing firm,

which is typical for the high-tech mergers.25

Technology transfer is another reason for merger. To stay innovative, the exploitation of

technological knowledge occupies a top ranking position in terms of motives and objectives

for such transactions. In acquiring technology from external sources, firms aim to promote

innovations that will improve their competitiveness. Thus, M&A transactions give access to

technology as a firm-specific resource. Such technology is otherwise largely immobile due to

24 See Reference 22. 25 ibid.

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high transaction costs. Generally the plan is to transfer from the target firm to the acquiring

firm, in terms of a technology-motivated transaction.26

There is an important difference between explicit technological know-how, which is found in

documentary form, such as patents, and implicit ‘tacit’ knowledge, which is tied up in a

firm’s personnel and therefore very often hard to identify, record and copy.

The transfers of technological resources aim to create a superior value.

4.4 Surplus Funds

Generating huge amount of cash but having few profitable investment opportunities, is

another reason for mergers. Most of the companies distribute the surplus cash to shareholders

by two mechanisms: by increasing theirs dividend payment or by stock repurchasing.

However, in dividend payment investors should pay higher taxes compared to a stock

repurchase, where investors should pay less taxes. But still, if the only reason is to avoid the

taxes on dividends, the second mechanism is illegal.

Yet, if the management of the company are not willing to purchase its own shares, they can

always invest the cash in purchasing the shares of another company. Other companies which

own surplus funds and do not pay cash back to stockholders, or spread and reinvest the funds

in reliable acquisitions, often end up targeted for a takeover by a larger company, which

propose to do it instead of them.27

26 http://www2.druid.dk/conferences/viewpaper.php?id=111&cf=8 – Druid Conference: Journal Industry and Innovation, published by Routledge, p. 3. 27 Brealey, Myers & Allen – ‘Corporate Finance’, 8th Int. Edition, McGraw-Hill Publishing (2006); Ch. 32 / p. 875

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4.5 Industry Consolidation and Monopoly Gains

The main motive in industry consolidation is to reduce the costs. Although sometimes the

consolidation in some industry might be inevitable, due to different sector crisis and excess

participants in the economy, the takeovers contribute to become faster.28

Yet, merging with a competitor in the industry gives the company a major share in the

market, therefore increases its power and profits compared to the rest participants, which

usually should be controlled and prevented by different antitrust laws and organizations.29

However, we can apply these anti-monopoly strategies only to the developed and modern

countries as the policy is more transparent and visible.

4.6 Eliminating Inefficiencies

Takeovers often take place because the acquirer’s management believe that they can run the

company better. It is supposed that the main reason for an unsuccessful company is the

inefficient management of the target company and that is why it should be replaced. There

are also other assets and liabilities despite cash which could be managed inefficiently, and

companies with unexploited opportunities will always exist. As a result, because of the poor

management, they end up acquired by other companies. Of course the motives and potential

synergies are simply driven by the intension to eliminate the duplication through removing

and replacing the existing management. 30

28 See Reference 27 (and p. 876) 29 Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 896 30 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 789 (See Jensen & Ruback - http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.461.7261&rep=rep1&type=pdf_ The Market for Corporate Control)

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4.7 Tax Gains from Net Operating Losses

The reduction, respectively the gains can come from the use of tax losses.

A company with both profitable and unprofitable department will have low taxes, as they

compensate each other when they are combined. Conversely, if they are not combined and

are separate businesses, they will not be able to use the benefits mentioned above. Thus, a

merger can lower taxes.

Conglomerate has a tax advantage over a single-product firm, simply because of such

circumstances. Yet, mergers can sometime bring both profits and losses. A firm that has been

profitable but has a loss in the current year may be able to get refunds of income taxes paid

during the last three years, and can carry the loss forward for the next 15 years. Still, in many

countries, tax authorities are likely to prevent an acquisition to happen, if the main reason is

to avoid the tax payment.31 The tax advantages in mergers will differ from one location to

another. In the United States, the Internal Revenue Service (IRS)32 is the responsible

government agency for tax collection and tax law enforcement.

4.8 Diversification

Another benefit and reason for a merger is diversification. Those benefits and justifications

come in three major forms, as follows: risk reduction technique, lower cost of debt or

increased debt capacity, and liquidity strategy.

4.8.1 Risk reduction through diversification is a technique which reduces risk by distributing

the amount of the investment among different and various financial industries which are

31 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 790 32 https://www.irs.gov/ - The Official Website of US Internal Revenue Service

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correlated. The main objective is to receive high return and spreading the risk between areas

which react differently to a potential event. However, this could be done by the investor’s

portfolio as well, if it is well-diversified. Usually the larger the investor, the smaller the

possibility is for the company to rely on diversifying through acquisition. It is cheaper for

investors to manage and diversify their own portfolio, rather than doing it by the corporation.

This is a result of the potential agency costs, as in a conglomerate is difficult to measure the

performance of the management, and more precisely their motives.33

4.8.2 Debt capacity involves the assessment of the amount of debt that the company can pay

in a specific period of time. A merger, does not lead only to risk reduction as mentioned, but

it also generates greater tax shield and increased debt capacity. Two major options are

available. One of the possibilities is when the target has too little debt, the acquirer can fill

the target with the missing amount of debt. The other possibility is both companies to have

optimal debt levels.

Unused debt capacity is beneficial as more debt leads to a bigger tax shield, and each

company can borrow a certain amount before the marginal costs factors, as companies with

high risk rates cannot borrow as much as companies with low risk rates.

Some companies have less debt than is optimal. This is because their managers are either

reluctant to take risks, or do not how to evaluate the debt capacity correctly. Having too little

debt is dangerous as it reduces the firm’s value. Moreover, the company becomes a target for

a potential acquisition, as after merging, it will be possible to increase the debt level and

therefore to create a bigger tax shield.34

33 Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 898 34 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 791

20

This is a result of the higher interest payments after the merger, where the tax bill of the

combined firm after the merger are supposed to be less than the sum of the tax of each firm

individually before the merger. Therefore, the increased debt capacity can reduce taxes.

4.8.3 Liquidity can be a valuable and important objective for the target shareholders to agree

to the takeover, as a result of poor-diversified portfolio where they invested unequal part of

their wealth. According to that, acquirers give an opportunity to target shareholders to cash

out their investments from the company and to reinvest them in a well-diversified portfolio.35

4.9 Increasing Earnings and Lower Financing Costs

In spite of the fact that some acquisitions offer no evident economic gains, they are able to

increase earnings per share for several years.

‘The bootstrap game’ refers to a merger that actually has no gains or economic benefits to a

business. Most financial experts claim that the “bootstrap effect” happen when earnings per

share increase while there is no real gain created by the merger, and the combined value of

the two firms is equal to the sum of the separate values.36

Financial manipulators rely on the fact that the market does not understand the deal correct.

A ‘bootstrap game’ generates earnings growth as a result of buying slowly growing firms

with low price-earnings ratios, not because of capital investment or higher profit gains. To

keep deceiving the market and the investors, the firm has to continue to expand by merger of

the same rate. It is obvious that this cannot go on forever. One day expansion must slow

35 See Reference 33. 36 http://www.ehow.com/info_8684608_bootstrap-game-finance.html - ‘Pre and Post Merger P/E Ratios, and the Bootstrapping Game’, Washington University, USA.

21

down or stop, so at this point earnings growth per share and the stock price together fall

dramatically. 37

Nowadays the bootstrap game is not played very frequently, but still there are managers who

would rather acquire firms with low price-earnings ratios. It is false to suggest that mergers

can be evaluated just by looking at their immediate effect on earnings per share.

Lower financing costs is something more than just lower issue and borrowing costs. The

merged company can borrow at lower interest rates than each company individually, which

is normal to be expected, concerning a bond market which is performing well. Until the two

companies are not combined and remain individual, they cannot guarantee each other’s debt.

In other words, if one of the companies fail, the bondholder does not have the option to ask

the other for money, as it can happen if they were merged. Thus, in mergers when one part of

the business fails, the bondholders can still take their money out of the other part. This is the

reason why lenders give money at a lower interest rate to merged entities, as the risk is

guaranteed by more than one participant. Nevertheless, just because the merger received

lower interest rate does not mean that will bring a net gain. They receive this opportunity,

because they gave safer and more reliable protection to the bondholders. As merging

decreases the probability of financial distress, some managers become more confident and

less worried about potential issues, so they begin to borrow money through the increased

value of the combined firm at a lower interest rate, creating a bigger tax shield, and

respectively, a net gain to the merger.38

37 Brealey, Myers & Allen – ‘Corporate Finance’, 8th Int. Edition, McGraw-Hill Publishing (2006); Ch. 32 / p. 878 38 ibid.

22

4.10 Managerial Motives to Merge

By far, the majority of reasons described above were economically motivated and in interest

of the shareholders. However, managers sometimes have their own point of view and reasons

to merge. They are more focused on their own self-interest which most of the time are not in

the best interest of the shareholders. Managers are driven mainly by the financial award

through M&A bonuses or pure personal ambition. They behave selfish, their ego leads them

often to overconfidence as they want to attract the attention of the media in order to gain

better reputation. However, this overestimation of the own abilities and the target’s value can

explain why they fail. To summarize, when a bid is announced, the stock price drops,

especially when the deal is public, and the reason for that can be described by conflicts of

shareholders’ interests or management overconfidence. However, those kind of problems

“lie” on the foundations of the Agency cost theory, as in large corporations is difficult for the

shareholders to control and observe the managers. There are supposed to be methods which

are in support of the anti-agency problems, but still, many observers believe that it is

impossible to deal with it.39

Overconfidence by management is another reason to merge.

Most of them who fail just do not want to realize that they are not as good as they think. The

‘hubris hypothesis’40 describes that overconfident managers lead M&A which have low

chance of creating value because they truly believe that they can deal with the existing

problems, and to succeed managing it better. (“hybris” in ancient Greek means

‘self-confidence’ and ‘extreme pride’; the characteristic of excessive confidence or

39 Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 900 40 http://pendientedemigracion.ucm.es/info/jmas/doctor/roll.pdf - Roll, R. – ‘The Hubrus Hypothesis of Corporate Takeovers’, The Journal of Business 59 (1986), p. 197; (citied Berk & DeMarzo)

23

arrogance, which leads a person to believe that he or she may do no wrong41). The hubris

hypothesis is an advanced explanation of corporate takeovers, explaining why bids are made

and payed too much when the potential target has a negative value.

The key factor between the conflict of interests and overconfidence is actually that when

overconfidence occurs, managers really believe that they are taking the right decision and in

the interest of the shareholders. However, the end result is quite similar and have basically

the same impact, as both actions are increasing the managements’ wealth and decreasing the

shareholders’.

5 The Valuation, The Offer and

The Deal Structuring of a Merger

The takeover process is complex, because the valuation often includes matters like

synergy and control, which go beyond just valuing a target firm. There are valuation methods

that rely on cash flows, which are divided in direct (absolute) or indirect (relative)42

valuations methods, such as discounted cash flow (DCF) or price-to-cash-flow ratio. There

are also valuation methods that rely on a financial variable other than cash flow like

economic income models and value analysis, or other ratios such as price-to-earnings ratio

(P/E), sales and enterprise value multiples. They show the total value of the target.

41 See https://en.wikipedia.org/wiki/Hubris - Etymology of the term ‘hybris’. 42 See http://www.ftpress.com/articles/article.aspx?p=2109325&seqNum=6 – Ferris, K. & Pettit, B., ‘Valuation of M&A: An Overview’, Financial Times Press (2013); part 5

24

The most important thing acquirers need to do is to define the advantages and disadvantages

of the potential target, to have clear and transparent motives for taking the right decision.

After that they have to decide the way they will pay for the deal. Finally they have to choose

the tax and accounting considerations, and explore the regulatory approval specifics. 43

After the acquirer has completed the valuation process and decides to do the merger, the

management start a tender offer. This is a public announcement for the intentions of the

bidder, who wants to purchase a large amount of the target’s shares, involving the price of

the deal and the deadline of accepting or rejecting it. Respectively, this determines whether

the takeover will be friendly or hostile.44

5.1 The Net Present Value of a Merger – Gains and Costs

The companies normally prefer the net present value analysis (NPV) when considering a

takeover, especially when they intend to use cash instead of stock - the first option is more

simple, and the second is more complex. The net present value is equal rather to the gains,

than the cost, due to the way of payment. When cash is used, it depends only on the amount

paid and in cash mergers all benefits go only to the acquirer. When stock-for-stock payment

is used, the benefits are shared both by the acquirer and target companies, as the target

receives a fair share percentage from the newly combined firm. However, analysis and

valuation of a target are often quite subjective as it is very hard and challenging to estimate

the accurate benefits. This leads to different ways of identifying the net present value of a

43 See http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/AcqValn.pdf - Damodaran, A., ‘Acquisition Valuation’ Paper, Stern School of Business NYU, USA; p. 3 44 Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 901

25

merger, but all of them involve similar methods, in which the forecast is based on returns,

risk, and financing the potential deal.45

The most important factor of the process of valuation and analysis is to define whether there

is an economic gain from the merger (Function 1), thus it is necessary for the merger to

achieve effects of synergy and to have higher value when companies are combined than each

individually, which is shown as:

Function 1. Merger Gain formula:46

Gain = PVab – (PVa + PVb) = ΔPVab,

Where the combined firm is PVab, and each individually worth respectively PVa and PVb,

thus only if the results is positive, the merger will be reasonable.

The cost of the acquiring firms is also very important, especially when made in cash

(Function 2). The cost is going to be equal to the cash payment minus the value of the target

as a separate entity, thus:

Function 2. Merger Cost formula:47

Cost = Cash paid – PVb

45 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 795 46 For Function 1, 2, 3 and 4 See: Brealey, Myers & Allen – ‘Corporate Finance’, 8th Int. Edition, McGraw-Hill Publishing (2006); Ch. 32 / p. 881 47 See Reference 46.

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The net present value to the acquiring company of merging with the target (Function 3) is

measured by the difference between the gain and the cost. Therefore, the NPV of the merger

is positive, if:

Function 3. NPV of a Merger48

NPV = Gain – Cost = ΔPVab – (Cash – PVb)

To summarize, the cost is actually the premium that the bidder pays for the target over its

individual value. Thus, a takeover should occur if the acquiring company’s gains are more

compared to the costs.

5.2 Right and Wrong Ways to Estimate Benefits

The process of estimating a business is not simple, it is complex and dangerous. There are no

easy ways to identify good mergers or acquisitions, but the most important thing is to gain

and achieve competitive advantages, compared to the other participants from the same

industry, on a reasonable price. However, acquirers should be careful about the moves and

tactics which the target firm is supposed to do, as it might put itself in an auction where the

bidders compete against each other and give higher price. Often the price is more expensive

than the actual and this must be taken into consideration, if it’s worth or not. Rumors about a

potential bid for the target can also increase its share price up in anticipation of the premium

offer.49

48 Ibid. 49 Ibid, p. 882

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In analysis, the estimated net gain (Function 4) can become greater because of mistakes of

overestimating the cash-flow, and not that much because of the forecasted benefits and

synergies. Vice-versa, sometimes the opposite happens and the potential is underestimated

by analysists.

Function 4. Estimated Net Gain formula

Estimated = DCF valuation of target, – Cash required

Net Gain including merger benefits for acquisition

Discounted cash-flow technique including the benefits, deducting the payment method, can

be used to determine the potential net gain in the merger. Future cash-flows forecasts and

discounting rates for target’s share price are needed, if the purpose is valuation of a company

as an individual business. After this action, the result should be compared to the actual share

price, but it is quite possible that they do not match and big fluctuations occur instead. Thus,

it should be analyzed deeper as this is the essence of the further consequences in terms of the

takeover benefits and premiums payed. Usually, nobody knows better than the managers

about the situation in their own companies. If the takeover is friendly, not hostile, the target

managers can provide this hidden information also known as asymmetric. This will skip the

potential investigation process and give a better, clearer perspective for the acquirers to act.

However, if the takeover is hostile, not friendly, the lack of such information and potential

gaps in the analysis, can block and fail the valuation process due to inaccuracies.50

50 Ibid.

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5.3 Valuation of the Synergies

This stage of the takeover valuation process concerns the assessment of the benefits of a

possible merger or acquisition. To do this, first the synergies must be estimated, which could

be quite vague and unclear. Acquirers often fail to bring the promised operation or financial

synergies. Obviously this is the main reason why mergers and acquisitions occur on the first

place, and no doubt, in each takeover a synergy can be created. However, the key is to

estimate the size of the synergy and to decide whether the price is reasonable or not. After

all, M&A worth billions and will not be serious if investment bankers and managers cannot

give systematic explanation why such a big premium is being paid. Some synergies are

easier to predict such as tax benefits due to shields or higher margins due to economies of

scales, but other are harder to be predicted such as cash-flows and future gains or costs. They

are risky and dangerous as well. 51

To conclude considering the valuation process up to now, the M&A should go ahead if the

costs of the takeover, including the bid premium, as well as all transaction costs, are lower

than the combined value of the takeover.

5.4 Stock-Financed Merger and Asymmetric Information – Cash versus Stock

The two methods which an acquirer can use to pay for a target are through cash or stock.

In a cash transaction, the bidder pays for the target, including any premium in cash. In a

stock transaction, the bidder pays for the target by issuing new stock and giving it to the

target shareholders. The choice of payment method depends on the following arguments.

51 See Damodaran, A. – ‘The Value of Synergy’, NYU Stern School of Business, USA (2005), p. 5 - http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf

29

A stock-for-stock method can be cheaper if the acquiring management believes that the stock

of their own company are overestimated by the market. A cash acquisition is usually

preferred by the shareholders of the target company as they are able to avoid the uncertainty,

and are aware of the potential risks which stock acquisition hides. Also it is more expensive

because it is taxable. However, the use of stock distributes the risk as the combined firm will

share all the profits and losses.52

The other difference between cash and stock financing for mergers is related to the

information which the target managers possess about specific parts of the business or

technological units that only they know. This knowledge is usually unknown by other people

and as mentioned above is referred to ‘asymmetric information’. Sometimes the merger

looks more positive for investors than its actual situation. However, there are some tricks

during the negotiating process which can navigate the managements of the two companies

for potential threats as questions can raise. This specific lack of knowledge and information

can be devastating due to the advantages and benefits which were predicted in first place,

and to destroy them as well.53 Not very moral, but normal as in business happens frequently,

especially when large sums of money are involved.

5.5 Merger Arbitrage

Nothing guarantees that a takeover will exist, even after a tender offer is announced, not at

least for the negotiated price. The target often bargains and raises the price and another

possibility is simply the offer to fail. When an acquirer bids for a target, the target’s firm

52 Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 902 53 Brealey, Myers & Allen – ‘Corporate Finance’, 8th Int. Edition, McGraw-Hill Publishing (2006); Ch. 32 / p. 885

30

board can reject the bid even if a large premium is offered. The target board is not the only

obstacle for the bidder. Even if they agree, the regulators could disagree and disapprove

when antitrust laws are concerned.

As mentioned above, two principal types of merger are possible: a cash merger, and a stock

merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a

certain price in cash. Until the acquisition is completed, the stock of the target typically

trades or exchanges shares below the purchase price. An arbitrageur buys the stock of the

target and makes a small profit if the acquirer eventually buys the stock, but the arbitrageur

must be aware of each potential move as it is risky and may be fatal for their investment, thus

big losses are possible.54

It is possible for investors to speculate on the outcome of the deal, as uncertainty is involved.

Those arbitrageurs, who believe that they can predict the outcome of a deal, take positions

according to their expectations. However, arbitrageurs are not literally investors, because

they are not usually buying or selling securities, based on their investment value. But still,

they have to participate in the risky part of the deal, not at the risk of the market.

There is a certain and well-known set of order which helps arbitrageurs to take decisions:55

Arbitrageurs have to gather information about the particular deal and then calculate the value

of the securities offered. After that they have to define how much time will the capital be

related in the deal and to estimate the risk opportunities of potential failure of the transaction.

54 Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 903 55 http://www.fxf1.com/english-books/Wyser-Pratte,%20Guy%20-%20Risk%20Arbitrage.pdf – Wyser-Pratte Guy P. – ‘Risk Arbitrage II’, Salomon Brothers Publishing, Center for the Study of Financial Institutions at the Graduate School of Business Administration, New York University, USA. (p. 22 in the book / p. 34 in the link)

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Next, an assessment of the various tax consequences, and at the end, a tax strategy is

important to be created according to them.

6 The Mechanics of a Merger and

Post-Integration Issues

Buying a whole company is not that easy as buying a particular business unit or using

specific services. The mechanics in M&A are extremely complex as there are many details

which can reflect the takeover process. Therefore, it is highly recommended to be consulted

and specialists to be hired in the legal, and tax and accounting area.

6.1 Mergers and Antitrust Law and Popular Opposition

Many governments intervene and participate in time of mergers and acquisitions in order to

reduce and control or maintain the monopoly gain. In the majority of the cases, antitrust laws

have rather formally relation or attitude than a potential barrier. However, the process is

unpleasant and time wasting as plenty of bureaucracy is involved, but if the deal does not

raise any serious reasons in terms of reducing competition due to monopoly gains and huge

share in a specific market, there will not be any big troubles and negative consequences.56

56 Brealey, Myers & Allen – ‘Corporate Finance’, 8th Int. Edition, McGraw-Hill Publishing (2006); Ch. 32 / p. 886

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6.1.1 European Commission

The main legislative texts for merger decisions in Europe is the European Commission (EC)

‘Merger Regulation and the Implementing Regulation’ law. The Merger Regulation contains

the main rules for the assessment of concentrations, whereas the Implementing Regulation

concerns procedural issues, such as notification and deadlines.57

The Commission has also published "Best Practice Guidelines" which concern the

relationship between the commission and the participants during the procedure, such as pre-

notification contacts, meetings, and provision of documents. The Commission has also

published model texts for divestiture commitments and responsibilities in ‘EU Competition

Law – Merger Legislation’58, in order to provide better guidance to the participants in terms

of requirements.

6.1.2 U. S. Department of Justice and Federal Trade Commission

In the United States, the responsible legislative authorities for mergers and acquisitions are

the Department of Justice 59 and the Federal Trade Commission (FTC)60. They track and

observe each significant transaction and approve or take decision to slow down the takeover

process, or even to postpone it. The most important rule is the ‘Clayton Act of 1914’, which

forbids an acquisition whenever “in any line of commerce or any section of the country” the

effect “may be substantially to lessen the competition, or to tend to create a monopoly”61.

Both authorities can regulate and enforce the antitrust laws. Yet, another important

57 http://ec.europa.eu/competition/mergers/legislation/legislation.html - The Official Website of EC. 58 http://ec.europa.eu/competition/mergers/legislation/merger_law_2013_web.pdf - Online version of the Legislation and the Guidance Documents, electronic format, 1.07.2013. 59 http://www.justice.gov/ - The Official Website of the U. S. Department of Justice 60 https://www.ftc.gov/ - The Official Website of the Federal Trade Commission. 61 *Cited: Brealey, Myers & Allen – ‘Corporate Finance’, 8th Edition, McGraw-Hill Publishing (2006); p. 886

33

regulation obstacle is The Hart-Scott-Rodino Antitrust Act62 of 1976. This requires the

agencies to be informed of all acquisitions of stock amounting to $15 million or 15 percent

of the target’s stock. The risk of unfair transaction to occur is small, as most significant deals

are review in an early stage.

The antitrust laws present serious obstacles in a significant minority of mergers. In those

cases, the EC or the U. S. Department of Justice and the FTC, which share responsibility for

trust enforcement, either may sue to block the deal, or may call for major revision or

restructuring. Private companies also may challenge mergers in the courts, although this

rarely happens except in hostile tender offers, but still is enough to postpone the takeover and

further precautions to be taken by the target against the intensions of the bidder.

As there are plenty of options available to antitrust authorities, the companies have to be

accurate and transparent about their motives in order to obtain government clearance and

fulfill the necessary requirements. This could support the decision of the authorities and lead

to the end result, whether the deal will be allowed and go forward, or blocked.

6.2 The Form of Acquisition

If there are no any evidence that an antitrust issues will occur, the next step is to decide and

choose what will the form of acquisition be. There are three major possibilities to do so. The

first of them is to merge the companies, but at least half of the stockholders’ approval of the

target company is needed, as the acquirer will assume all the assets and the liabilities under

its management and ownership. Another option is to buy the target’s stock in for cash or in

62 Rock, M. – ‘The Paper Chase: Regulation, Communication, and Defenses’, McGraw-Hill Publishing, USA; Ch. 36 Antitrust Guidelines by D. Rosenthal & W. Blumenthal / p. 401

34

exchange of shares and other securities. In the second case the acquirer does not need the

approval of the board or management, and can deal individually with the target’s

shareholders. The third possibility is to purchase most or all of the target’s assets. In result of

that the right of property must be titled, and the stockholders of the target are bypassed

indirectly as the payment is made directly to the company.63

6.3 Merger Accounting and Tax Issues:

After the terms of the deal are chosen, the next step is to decide which tax and accounting

method can be involved and established. The management has to find the most gainful way

to register the purchase in its financial statement. Until 15 years ago (2001) the company had

a choice of which accounting method to be used, but in that year the Financial Accounting

Standards Board (FASB) introduced new rules that required to use the purchase method of

merger accounting.64 Many mergers involve companies in two different countries, which

presents many difficulties in estimating the benefits of acquisitions. This is because

accounting and tax rules can be very different across countries.

Two of the most powerful global trade participants – the USA and the European Union have

different accounting systems and standards. However, they are trying to bring the rules into a

common framework as none of them can afford to stay out of the game, no matter how big

their influence or economy is. In Europe, and many other countries, International Financial

Reporting Standards65 (IFRS) govern the accounting transactions of the companies. In the

63 Brealey, Myers & Allen – ‘Corporate Finance’, 8th Int. Edition, McGraw-Hill Publishing (2006); Ch. 32 / p. 887 64 http://www.fasb.org/summary/stsum141.shtml - The Official Website of FASB, ‘Summary of Statement No. 141 – ‘The Purchase Method, revised (2007). 65 http://www.ifrs.org/Pages/default.aspx - The Official Website of IFRS.

35

United States, the responsible organization is the Financial Accounting Standards Board66

(FASB). Both of them, the IFRS and FASB, co-operate together and work on developing a

common framework. As an ongoing project, which involves many national standards, the

process is going to be slow but developments continue to improve and will get better in

future.

Both organizations conclude that the accounting treatment of any M&A should involve fair

value of all assets and liabilities. The following merger accounting method, proposed by

IFRS3 Business Combinations67 involves several steps such as: identifying of the acquirer,

through a separate accounting standard - IAS27 Consolidated and Separate Financial

Statements68, which is used to identify the company that has gained control in the merger

transaction. This can be quite difficult, especially when the merger is a merger of

equals; the second step is to determine the acquisition date, which is normally the date of

legal transfer between the companies; next, it is important to recognize and measure the

assets and liabilities; and at the end, to measure the goodwill.

The acquirer’s payment method for the target is in both shareholders’ interests as it affects

the taxes of the companies. The acquisition can be taxable or tax-free, or at least postponed

in time if the new shares are sold. In this sense, cash acquisitions is taxable and stock

acquisition is tax-free. There is another option when the acquirer purchases the target assets

directly, the book value will also increase. This leads to creating a goodwill, which is an

66 http://www.fasb.org/home – The Official Website of FASB. 67 http://ec.europa.eu/internal_market/accounting/docs/consolidated/ifrs3_en.pdf – IFRS3, ‘Business Combinations’, EC, consolidated version (2011). Cited by (Hiller, D. & Ross, S. – ‘Corporate Finance’ p. 812) 68 http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias27_en.pdf – IAS 27, ‘Consolidated and Separate Financial Statements’, (2009).

36

intangible asset that arises through a premium value after an acquisition. It is difficult to

price the goodwill of a company but it makes the company more valuable due to good

customer relations or patents of technology. It is important for the acquirer not to

overestimate the potential goodwill, as the factors involved are quite subjective.

The accounting treatment of M&A is moving toward one basic standard across the world,

and governments are also helping and trying to integrate national tax laws inconveniences.

The taxation of M&A across national border can be extremely complex and can cost a lot,

which discourages many corporations from pursuing cross-border mergers.

Yet, there have been a number of treaties that smooth out the differences, in order to unite

the differences across the world.

7 Do Mergers Add Value and Generate Net

Benefits – Who Gets them?

For years, the value of mergers and acquisitions has been discussed. Do mergers add

value and generate net benefits, and if so, who gets them – as this is an empirical question,

the answer will be given and supported by empirical evidence. Although, there are many

ways to estimate value creation, most academics prefer event studies and a recent one is

going to be briefly summarized next.

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7.1 Do Mergers Add Value and Generate Net Benefits?

Mergers can create value from different sources of synergies. If the value of the combined

company is greater than the sum of each individually, therefore a synergy occurs, and

respectively value is added. 69

Although most mergers added value, yet, mergers which involve the biggest companies have

lost value. Mergers and acquisitions in Europe are not as popular as in the USA. Takeovers

have been driven by different motives. Usually, the most common motives are the

exploitation of different synergies and expanding into new markets. However, when a crisis

occurs, such as the last in 2008, many companies are forced to merge due to financial

distress and economic necessity. Another barrier which can destroy the value and the

interest in a potential merger, is the different regulatory and legal framework which each

country has.

Today, companies continue to keep making acquisitions so that they can increase their

market share, expand geographically, and diversify into other industries. In a recent report

was confirmed that the generally accepted theory and belief about M&A does not have all

the necessary parts or appropriate tools, and is imperfect. Most of the studies agree that

mergers add value around the date of announcement.

7.1.1 Four years ago, in a study from November 2011, done by researchers at the M&A

Research Centre at Cass Business School in London70, was proven that in the first three years

after the takeover was announced, the majority of deals did not add value according to the

share-price performance. Nevertheless, there was no doubt that successful deals added more

69 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 807 70 http://ww2.cfo.com/ma/2012/06/do-mergers-add-value-after-all/ - ‘Do Mergers Add Value After All’, Sawyers, A., CFO Magazine, 2012.

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value than unsuccessful destroyed in the researching sample of more than three thousand

companies from the United Kingdom during the period 1997-2010.

In the long-term, taking everything into account, 4 months between and 36 month after the

deal was announced (Figure 3), has been found that takeovers add value in the period prior

the deal, and the share prices of the acquirer performed better at a peak of 7.5%, according to

the FTSE71 index, in the first 3 months after the deal. However, after that, the return stars to

get lower and 3 years after the deal, eventually reached 1.2%. In conclusion was suggested

that “the more cash in the mix, the more successful the deal”.

Figure 3. Long-term adjusted total return for acquirers, adjusted to the FTSE All-Share

Index

71 http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/indices/summary/summary-indices.html?index=ASX – The FTSE All-Share Index, originally known as the FTSE Actuaries All Share Index, is a capitalization-weighted index, comprising around 3,000 companies traded on the London Stock Exchange. FTSE All-Share is the aggregation of the FTSE 100 Index, FTSE 250 Index and FTSE SmallCap Index.

39

The study was commissioned by The UK government’s Department for Business, Innovation

and Skills. In support, Andrew Sawyers confirms “The Economic Impact of

M&A: Implications for UK Firms”, where not only were not provided any significant

evidence that hostile takeovers are value destroying in the long run, but it also was proven

that actually, acquirers involved in hostile deals generate more shareholder value, compared

with those involved in friendly takeovers.

Although it is obvious that mergers on industry concentration and firm size add value, it is

unlikely the result to be the same for the social welfare.

7.1.2 The Managers versus The Shareholders

Most of the time, takeovers present problem and conflict of interests between management

and shareholders, as acquisition is one possibility for the managers to spend large sum of

money, instead of paying it out to the shareholders. It is typical for managers to take on and

to commit less-beneficial deals and takeover actions, especially if they have a lot of free cash

flow or borrowing power. In such cases, usually managers will gain more than shareholders

due to bonuses, commissions and other motives, described by the Agency theory. Managers

are supposed to look from the perspective of the shareholders, as they are the one who elect

the board and the one who pay, but in practice, this loyalty should not be expected in the

financial world, as everything is up to self-interests and private gains, especially when large

sums of money are involved and still, shareholders cannot control the managers efficiently.

In result of this lack of control by the shareholders, the managers make worse decisions and

work less, but get paid more. Even are stimulated to grow the size of their corporations

through mergers and acquisitions, because of their contracts and payment details. Agency

40

theory, or the overconfidence combined with lack of transparency by the management, could

easily explain why the biggest merger failures have involved large firms.72

On the other hand, a similar problem exists in the relationship between the target

shareholders and the target management. If a merger is inevitable and impossible to prevent,

target management is possible to negotiate for their future or benefits with the acquirer, at the

expense of the target’s shareholders. One potential way to do this, is through cutting the

premium of the deal.

7.2 Who Gets the Value Added from a Takeover?

After it was proven that hostile takeovers add more value than the friendly takeovers, the

main benefit, in terms of paid premium, remains to be generated by the targets’ shareholders,

which premium is always higher than the actual price, according to the market. Because of

the supposed synergies, usually the bidder pays average the target a premium of 40 to 50 per

cent of the current price. However, acquiring shareholders take a risk as they could lose from

the deal, if the premium is more than the estimated synergies. Therefore takeovers generate

safer net benefits to the target shareholders. Even if the bidder shareholders have calculated

the gains and costs correctly, this does not mean that there will not be any further issues in

the long-term.73

72 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 811 73 For Reference 75 & 76; See Reference 73: Berk, J., DeMarzo, P. – ‘Corporate Finance’ 2nd Global Edition, Pearson Education, UK (2011); Ch. 28 / p. 910

41

7.2.1 A Note About Leveraged Buyout

LBOs and Mergers have much in common. In a leveraged buyout the cash offer price is

financed with large amounts of debt, most of it which is junk. This allows the bidders to meet

the acquisitions costs without using any

significant amount of capital investment, as the rest of the capital is usually supported by

a small group of investors. They could be existing managers of the target company or

indirectly connected with them. Such transactions are also known as management buyouts.

To explain the LBO, two factors are important to be taken into consideration – the additional

tax shield, and efficiency gains. Since the tax shield is simpler to be measured due to the high

debt rates, the second part, according to the increased efficiency remain quite subjective and

harder to evaluate. Without any doubt, the LBO mechanism is again in favor and interest of

the target’s shareholders as they get paid a premium just like in a merger. 74

Nevertheless, the risk is huge, as great leverage is involved. LBO can be compared to a

double-edged knife as this tactic can either make a fortune or cause bankruptcy.

7.2.2 The Freeze-out Merger

Alternative mechanism to the leveraged buyout is the freeze-out merger.

This is an action where the majority of the shareholders of the target forces the minority to

sell their shares. After a tender offer is announced and accepted, the non-tendering holders

lose their shares as the target is already acquired and does not exist anymore. Then, they

receive the right to review the tender offer and as long as the price is fair, in terms of higher

than before the takeover process, there is no possibility for legal consequences to exist.

74 Hiller, D. & Ross, S. – ‘Corporate Finance’ EU Edition, McGraw-Hill Publishing (2013); Ch. 29 / p. 814

42

In a freeze-out merger the acquirer could pay either with cash or debt to the minority of the

target’s shareholders.75

7.2.3 Competition

To summarize, all mentioned above, competition is another reason which can explain the

high cost of the premium, paid by the acquirers to the target’s shareholders, despite of the

availability of the previous mechanisms – LBO and Freeze-out merger. When an acquirer

discovers important and worthy synergy effects and gains, other acquirers could also want to

bid for the target company. This basically leads to an auction, where the target is waiting to

accept the highest price. Therefore, the acquirer has to sacrifice most of the value added in

benefit to the target’s shareholders, and to pay large premium, which purpose is to avoid

potential auction and further inconveniences.76

75 See Reference 73 (and p. 914) 76 Ibid., p. 915

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8 Conclusion

Most of the companies believe that the best way to become more successful and to

make higher profit, is through mergers and acquisitions. Such a market growth is expected

by the managements, board of directors, shareholders and investors, because of the fact that

M&A can create synergies, economies of scale, expanding operations, increasing earnings

and cutting costs. There are several types and forms of M&A, and it is important to analyze

each of them, the potential gains and costs which they involve, in order to take and choose

the most beneficial deal. The valuation process, the offer and the deal structuring are

complex, as they involve different methods and mechanisms. However, to combine two

firms, is not enough to have the board or shareholder approval, but it is require to have the

antitrust regulators approval as well. Although, the managerial motives behind a takeover are

questionable and dubious, companies continue to keep making acquisitions so that they can

increase their market share, expand geographically, and diversify into other industries.

After all, it is proven that mergers create more value than they destroy, but still, the net

benefits from M&A deals remain to be generated by the target’s shareholders. The majority

of business observers believe that M&A trend is progressive and the activity is going to

increase even more, so in the long term we should not be surprised to see more frequent

and larger deals.

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