Mergers and Acquisitions

Chapter 19 Mergers and Acquisitions

Key Concepts and Skills • Be able to define the various terms associated with M&A activity • Understand the various reasons for mergers and whether or not those reasons are in the best interest of shareholders • Understand the various methods for paying for an acquisition • Understand the various defensive tactics that are available

19.1 The Legal Forms of Acquisitions 19.2 Taxes and Acquisitions 19.3 Accounting for Acquisitions 19.4 Gains from Acquisition 19.5 Some Financial Side Effects of Acquisitions 19.6 The Cost of an Acquisition 19.7 Defensive Tactics 19.8 Some Evidence on Acquisitions: Does M&A Pay? 19.9 Divestitures and Restructurings Chapter Outline

19.1 The Legal Forms of Acquisitions • There are three basic legal procedures that one firm can use to acquire another firm: • Merger or Consolidation • Acquisition of Stock • Acquisition of Assets

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

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

Merger Acquisition Acquisition of Stock Proxy Contest Acquisition of Assets Going Private (LBO) Varieties of Takeovers Takeovers

19.2 Taxes and Acquisitions • If it is a taxable acquisition, selling shareholders need to figure their cost basis and pay taxes on any capital gains. • If it is not a taxable event, shareholders are deemed to have exchanged their old shares for new ones of equivalent value.

19.3 Accounting for Acquisitions • The Purchase Method • The source of much “goodwill” • Pooling of Interests • Pooling of interest is generally used when the acquiring firm issues voting stock in exchange for at least 90 percent of the outstanding voting stock of the acquired firm. • Purchase accounting is generally used under other financing arrangements.

19.4 Gains from Acquisition • Most acquisitions fail to create value for the acquirer. • The main reason why they do not lies in failures to integrate two companies after a merger. • Intellectual capital often walks out the door when acquisitions aren't handled carefully. • Traditionally, acquisitions deliver value when they allow for scale economies or market power, better products and services in the market, or learning from the new firms.

S T DCFt Synergy = (1 + r)t t = 1 Synergy • Suppose firm A is contemplating acquiring firm B. • The synergy from the acquisition is Synergy = VAB – (VA + VB) • The synergy of an acquisition can be determined from the standard discounted cash flow model:

Sources of Synergy • Revenue Enhancement • Cost Reduction • Replacement of ineffective managers • Economies of scale or scope • Tax Gains • Net operating losses • Unused debt capacity • Incremental new investment required in working capital and fixed assets

Calculating Value • Avoiding Mistakes • Do not ignore market values • Estimate only Incremental cash flows • Use the correct discount rate • Don’t forget transactions costs

19.5 Some Financial Side Effects • Earnings Growth • If there are no synergies or other benefits to the merger, then the growth in EPS is just an artifact of a larger firm and is not true growth (i.e., an accounting illusion). • Diversification • Shareholders who wish to diversify can accomplish this at much lower cost with one phone call to their broker than can management with a takeover.

19.6 The Cost of an Acquisition • Typically, a firm would use NPV analysis when making acquisitions. • The analysis is straightforward with a cash offer, but gets complicated when the consideration is stock.

Cash Acquisition • The NPV of a cash acquisition is: • NPV = (VB + ΔV) – cash cost = VB* – cash cost • Value of the combined firm is: • VAB = VA + (VB* – cash cost) • Often, the entire NPV goes to the target firm. • Remember that a zero-NPV investment may also be desirable.

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

19.7 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

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

19.8 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.

Evidence on Acquisitions • Shareholders of bidding firms earn a small excess return in a tender offer, but none in a straight merger: • 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.

19.9 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

Quick Quiz • What are the different methods for achieving a takeover? • How do we account for acquisitions? • What are some of the reasons cited for mergers? Which of these may be in stockholders’ best interest and which generally are not? • What are some of the defensive tactics that firms use to thwart takeovers? • How can a firm restructure itself? How do these methods differ in terms of ownership?

Mergers and Acquisitions