Chapter 26

Mergers and Acquisitions

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

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

with M&A activity• Understand the various reasons for mergers and

acquisitions and whether or not these reasons are in the best interest of shareholders

• Understand the various methods for paying for an acquisition and how to account for it

• Understand the various defensive tactics that are available

• Understand how to value the transaction and estimate the gains from the merger or acquisition

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Chapter Outline• The Legal Forms of Acquisitions• Taxes and Acquisitions• Accounting for Acquisitions• Gains from Acquisition• Some Financial Side Effects of Acquisitions• The Cost of an Acquisition• Defensive Tactics• Some Evidence on Acquisitions: Do M&A

Pay?• Divestitures and Restructurings

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Merger versus Consolidation

• Merger– One firm is acquired by another– Acquiring firm retains name and acquired firm

ceases to exist– Advantage – legally simple– Disadvantage – must be approved by

stockholders of both firms• Consolidation

– Entirely new firm is created from combination of existing firms

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

purchasing voting shares of the firm’s stock• Tender offer – public offer to buy shares• Stock acquisition

– No stockholder vote required– Can deal directly with stockholders, even if management is

unfriendly– May be delayed if some target shareholders hold out for more

money – complete absorption requires a merger• Classifications

– Horizontal – both firms are in the same industry– Vertical – firms are in different stages of the production process– Conglomerate – firms are unrelated

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Takeovers

• Control of a firm transfers from one group to another

• Possible forms– Acquisition

• Merger or consolidation• Acquisition of stock• Acquisition of assets

– Proxy contest– Going private

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Taxes• Tax-free acquisition

– Business purpose; not solely to avoid taxes– Continuity of equity interest – stockholders of target firm

must be able to maintain an equity interest in the combined firm

– Generally, stock for stock acquisition

• Taxable acquisition– Firm purchased with cash– Capital gains taxes – stockholders of target may require

a higher price to cover the taxes– Assets are revalued – affects depreciation expense

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Accounting for Acquisitions• Pooling of interests accounting no longer allowed• Purchase Accounting

– Assets of acquired firm must be reported at fair market value

– Goodwill is created – difference between purchase price and estimated fair market value of net assets

– Goodwill no longer has to be amortized – assets are essentially marked-to-market annually and goodwill is adjusted and treated as an expense if the market value of the assets has decreased

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Synergy• The whole is worth more than the sum of

the parts• Some mergers create synergies because

the firm can either cut costs or use the combined assets more effectively

• This is generally a good reason for a merger

• Examine whether the synergies create enough benefit to justify the cost

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Revenue Enhancement

• Marketing gains– Advertising– Distribution network– Product mix

• Strategic benefits• Market power

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Cost Reductions• Economies of scale

– Ability to produce larger quantities while reducing the average per unit cost

– Most common in industries that have high fixed costs

• Economies of vertical integration– Coordinate operations more effectively– Reduced search cost for suppliers or customers

• Complimentary resources

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Taxes• Take advantage of net operating losses

– Carry-backs and carry-forwards– Merger may be prevented if the IRS believes the sole

purpose is to avoid taxes

• Unused debt capacity• Surplus funds

– Pay dividends– Repurchase shares– Buy another firm

• Asset write-ups

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Reducing Capital Needs• A merger may reduce the required investment in

working capital and fixed assets relative to the two firms operating separately

• Firms may be able to manage existing assets more effectively under one umbrella

• Some assets may be sold if they are redundant in the combined firm (this includes reducing human capital as well)

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General Rules

• Do not rely on book values alone – the market provides information about the true worth of assets

• Estimate only incremental cash flows• Use an appropriate discount rate• Consider transaction costs – these can

add up quickly and become a substantial cash outflow

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EPS Growth• Mergers may create the appearance of growth in

earnings per share• If there are no synergies or other benefits to the

merger, then the growth in EPS is just an artifact of a larger firm and is not true growth

• In this case, the P/E ratio should fall because the combined market value should not change

• There is no free lunch

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Diversification

• Diversification, in and of itself, is not a good reason for a merger

• Stockholders can normally diversify their own portfolio cheaper than a firm can diversify by acquisition

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

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Cash Acquisition

• The NPV of a cash acquisition is– NPV = VB* – cash cost

• Value of the combined firm is– VAB = VA + (VB* - cash cost)

• Often, the entire NPV goes to the target firm

• Remember that a zero-NPV investment is not undesirable

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Stock Acquisition• Value of combined firm

– VAB = VA + VB + V• Cost of acquisition

– Depends on the number of shares given to the target stockholders

– Depends on the price of the combined firm’s stock after the merger

• Considerations when choosing between cash and stock– Sharing gains – target stockholders don’t participate in

stock price appreciation with a cash acquisition– Taxes – cash acquisitions are generally taxable– Control – cash acquisitions do not dilute control

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Defensive Tactics

• Corporate charter– Establishes conditions that allow for a takeover– Supermajority voting requirement

• Targeted repurchase (a.k.a. greenmail)• Standstill agreements• Poison pills (share rights plans)• Leveraged buyouts

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More (Colorful) Terms• Golden parachute• Poison put• Crown jewel• White knight• Lockup• Shark repellent• Bear hug• Fair price provision• Dual class capitalization• Countertender offer

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Evidence on Acquisitions• Shareholders of target companies tend to earn excess returns

in a merger– Shareholders of target companies gain more in a tender offer

than in a straight merger– Target firm managers have a tendency to oppose mergers, thus

driving up the tender price

• Shareholders of bidding firms, on average, do not earn or lose a large amount– Anticipated gains from mergers may not be achieved– Bidding firms are generally larger, so it takes a larger dollar gain

to get the same percentage gain– Management may not be acting in stockholders’ best interest– Takeover market may be competitive– Announcement may not contain new information about the

bidding firm

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Divestitures and Restructurings

• Divestiture – company sells a piece of itself to another company

• Equity carve-out – company creates a new company out of a subsidiary and then sells a minority interest to the public through an IPO

• Spin-off – company creates a new company out of a subsidiary and distributes the shares of the new company to the parent company’s stockholders

• Split-up – company is split into two or more companies, and shares of all companies are distributed to the original firm’s shareholders

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Quick Quiz• What are the different methods for achieving a

takeover?• How do we account for acquisitions?• What are some of the reasons cited for mergers?

Which may be in stockholders’ best interest, and which generally are not?

• What are some of the defensive tactics that firms use to thwart takeovers?

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

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Ethics Issues• In the case of takeover bids, insider trading is

argued to be particularly endemic because of the large potential profits involved and because of the relatively large number of people “in on the secret.” – What are the legal and ethical implications of trading on

such information?– Does it depend on who knows the information?

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Comprehensive Problem• Two identical firms have yearly after-tax cash

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

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End of Chapter

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