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Outline 8

8.1 The Market for Corporate Control

8.2 Sensible Motives for Mergers

8.3 Dubious Reasons for Mergers

8.4 Evaluating Mergers

8.5 Merger Tactics

8.6 Leveraged Buy-Outs

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The Merger Market

Proxy battle for control of the board of directorsFirm purchased by another firmLeveraged buyout by a group of investorsDivestiture of all or part of the firm’s business

units

Methods to Change Management

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Recent Mergers

Acquiring Company Selling Company

Payment ($ billions)

American Online Time Warner 106.0Chevron Texaco 42.9JDS Uniphase SDL, Inc. 41.1Deutsche Telecom VoiceStream Wireless 29.4BP Amoco (UK) Atlantic Richfield 27.2Echostar Communications Hughes Electronics 25.8Hewlett-Packard Compaq Computer 25.0American Intl. Group American General Corp. 24.6Phillips Petroleum Conoco 24.2

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The Merger Market

Tools Used To Acquire Companies

Proxy Contest

Acquisition

Leveraged Buy-Out

Management Buy-Out

Merger

Tender Offer

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Sensible Reasons for Mergers

Economies of Scale

A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units.

$ $$Reduces costsReduces costs

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Sensible Reasons for Mergers

Economies of Vertical IntegrationControl over suppliers “may” reduce costs.Over integration can cause the opposite effect.

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Sensible Reasons for Mergers

Combining Complementary ResourcesMerging may results in each firm filling in the “missing pieces” of their firm with pieces from the other firm.

Firm A

Firm B

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Sensible Reasons for Mergers

Mergers as a Use for Surplus Funds

If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.

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Dubious Reasons for Mergers

DiversificationInvestors should not pay a premium for

diversification since they can do it themselves.

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Dubious Reasons for Mergers

The Bootstrap Game

Acquiring Firm has high P/E ratio

Selling firm has low P/E ratio (due to low number of shares)

After merger, acquiring firm has short term EPS rise

Long term, acquirer will have slower than normal EPS growth due to share dilution.

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Evaluating Mergers

QuestionsIs there an overall economic gain to the

merger?Do the terms of the merger make the company

and its shareholders better off?

????PV(AB) > PV(A) + PV(B)

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Evaluating Mergers

Economic Gain

Economic Gain = PV(increased earnings)

= New cash flows from synergies

discount rate

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Evaluating Mergers

Example - Given a 20% cost of funds, what is the economic gain, if any, of the merger listed below?

Cislunar Foods Targetco Combined Company

Revenues 150 20 172 (+2)

Operating Costs 118 16 132 (-2)

Earnings 32 4 40 (+4)

Economic Gain =4

.20= $20

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Evaluating Mergers

Estimated net gain

Estimated net gain = DCF valuation of target including synergies

- cash required for acquisition

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Merger Tactics

White Knight - Friendly potential acquirer sought by a target company threatened by an unwelcome suitor.

Shark Repellent - Amendments to a company charter made to forestall takeover attempts.

Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.

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Leveraged Buy-Outs

Unique Features of LBOs

Large portion of buy-out financed by debt

Shares of the LBO no longer trade on the open market