TYPES OF ACQUISITIONS

In general, acquisitions can be horizontal, vertical, or conglomerate. A horizontal acquisition takes place between two firms in the same line of business. For example, one tool and die company might purchase another. In contrast, a vertical merger entails expanding forward or backward in the chain of distribution, toward the source of raw materials or toward the ultimate consumer. For example, an auto parts manufacturer might purchase a retail auto parts chain. A conglomerate is formed through the combination of unrelated businesses. Another type of combination of two companies is a consolidation. In a consolidation, an entirely new firm is created, and the two previous entities cease to exist. Consolidated financial statements are prepared under the assumption that two or more corporate entities are in actuality only one. The consolidated statements are prepared by combining the account balances of the individual firms after certain adjusting and eliminating entries are made. Another way to acquire a firm is to buy the voting stock. This can be done by agreement of management or by tender offer. In a tender offer, the acquiring firm makes the offer to buy stock directly to the shareholders, thereby bypassing management. In contrast to a merger, a stock acquisition requires no stockholder voting. Shareholders wishing to keep their stock can simply do so. Also, a minority of shareholders may hold out in a tender offer. A bidding firm can also buy another simply by purchasing all its assets. This involves a costly legal transfer of title and must be approved by the shareholders of the selling firm. A takeover is the transfer of control from one group to another. Normally, the acquiring firm (the bidder) makes an offer for the target firm. In a proxy contest, a group of dissident shareholders will seek to obtain enough votes to gain control of the board of directors.

FINANCIAL ACCOUNTING FOR MERGERS AND ACQUISITIONS

The two principal accounting methods used in mergers and acquisitions are the pooling of interests method and the purchase method. The main difference between them is the value that the combined firm's balance sheet places on the assets of the acquired firm, as well as the depreciation allowances and charges against income following the merger. The pooling of interests method assumes that the transaction is simply an exchange of equity securities. Therefore, the capital stock account of the target firm is eliminated, and the acquirer issues new stock to replace it. The two firms' assets and liabilities are combined at their historical book values as of the acquisition date. The end result of a pooling of interests transaction is that the total assets of the combined firm are equal to the sum of the assets of the individual firms. No goodwill is generated, and there are no

charges against earnings. A tax-free acquisition would normally be reported as a pooling of interests. Under the purchase method, assets and liabilities are shown on the merged firm's books at their market (not book) values as of the acquisition date. This method is based on the idea that the resulting values should reflect the market values established during the bargaining process. The total liabilities of the combined firm equal the sum of the two firms' individual liabilities. The equity of the acquiring firm is increased by the amount of the purchase price. Accounting for the excess of cost over the aggregate of the fair market values of the identifiable net assets acquired applies only in purchase accounting. The excess is called goodwill, an asset that is charged against income and amortized over a period that cannot exceed 40 years. Although the amortization expense" is deducted from reported income, it cannot be deducted for tax purposes. Purchase accounting usually results in increased depreciation charges because the book value of most assets is usually less than fair value because of inflation. For tax purposes, however, depreciation does not increase because the tax basis of the assets remains the same. Since depreciation under pooling accounting is based on the old book values of the assets, accounting income is usually higher under the pooling method. The accounting treatment has no cash flow consequences. Thus, value should be unaffected by accounting procedure. Some firms, however, may dislike the purchase method because of the goodwill created. The reason for this is that goodwill is amortized over a period of years.

HOW TO VALUE AN ACQUISITION CANDIDATE

Valuing an acquisition candidate is similar to valuing any investment. The analyst estimates the incremental cash flows, determines an appropriate risk-adjusted discount rate, and then computes the net present value. If firm A is acquiring firm B, for example, then the acquisition makes economic sense if the value of the combined firm is greater than the value of firm A plus the value of firm B. Synergy is said to exist when the cash flow of the combined firm is greater than the sum of the cash flows for the two firms as separate companies. The gain from the merger is the present value of this difference in cash flows.

Advantages associated with an Acquisition of Assets.

The gains from an acquisition may result from one or more of the following five categories: revenue enhancement; cost reductions; lower taxes; changing capital

requirements; and a lower cost of capital. Increased revenues may come from marketing gains, strategic benefits, and increased market power. Marketing gains arise from more effective advertising, economies of distribution, and a better mix of products. Strategic benefits represent opportunities to enter new lines of business. Finally, a merger may reduce competition, thereby increasing market power. Such mergers, of course, may run afoul of antitrust legislation. A larger firm may be able to operate more efficiently than two smaller firms, thereby reducing costs. Horizontal mergers may generate economies of scale. This means that the average production cost will fall as production volume increases. A vertical merger may allow a firm to decrease costs by more closely coordinating production and distribution. Finally, economies may be achieved when firms have complementary resourcesfor example, when one firm has excess production capacity and another has insufficient capacity. Tax gains in mergers may arise because of unused tax losses, unused debt capacity, surplus funds, and the write-up of depreciable assets. The tax losses of target corporations can be used to offset the acquiring corporation's future income. These tax losses can be used to offset income for a maximum of 15 years or until the tax loss is exhausted. Only tax losses for the previous three years can be used to offset future income. Tax loss carry-forwards can motivate mergers and acquisitions. A company that has earned profits may find value in the tax losses of a target corporation that can be used to offset the income it plans to earn. A merger may not, however, be structured solely for tax purposes. In addition, the acquirer must continue to operate the preacquisition business of the company in a net loss position. The tax benefits may be less than their "face value," not only because of the time value of money, but also because the tax loss carry-forwards might expire without being fully utilized. Tax advantages can also arise in an acquisition when a target firm carries assets on its books with basis, for tax purposes, below their market value. These assets could be more valuable, for tax purposes, if they were owned by another corporation that could increase their tax basis following the acquisition. The acquirer would then depreciate the assets based on the higher market values, in turn, gaining additional depreciation benefits. Interest payments on debt are a tax-deductible expense, whereas dividend payments from equity ownership are not. The existence of a tax advantage for debt is an incentive to have greater use of debt, as opposed to equity, as the means of financing merger and acquisition transactions. Also, a firm that borrows much less than it could borrow may be an acquisition target because of its unused debt capacity. While the use of financial leverage produces tax benefits, debt also increases the likelihood of financial distress in the event that the acquiring firm cannot meet its interest payments on the acquisition debt.

Finally, a firm with surplus funds may wish to acquire another firm. The reason is that distributing the money as a dividend or using it to repurchase shares will increase income taxes for shareholders. With an acquisition, no income taxes are paid by shareholders. Acquiring firms may be able to more efficiently utilize working capital and fixed assets in the target firm, thereby reducing capital requirements and enhancing profitability. This is particularly true if the target firm has redundant assets that may be divested. The cost of debt can often be reduced when two firms merge. The combined firm will generally have reduced variability in its cash flows. Therefore, there may be circumstances under which one or the other of the firms would have defaulted on its debt, but the combined firm will not. This makes the debt safer, and the cost of borrowing may decline as a result. This is termed the coinsurance effect. Diversification is often cited as a benefit in mergers. Diversification by itself, however, does not create any value because stockholders can accomplish the same thing as the merger by buying stock in both firms.

Disadvantages associated with an acquisition of assets.

1) Liabilities When an attempt is made to purchase a business through shares, the purchaser then also obtains all of the current liabilities associated with the target business. 2) Pre-sale re-organisations A pre sale reorganisation is when a business is purchased through an acquisition of shares and some of the assets of the purchased business are not included in the sale. When this occurs, the purchaser is required to then strip out these assets before the acquisition is completed. This is generally regarded as complicated process. 3) Tax disadvantage There are also some tax disadvantages to a share acquisition, the main point here being that capital allowances are not available when purchasing a business through share acquisitions. Also, the taxable assets of the company are based on historical data and any differences in the data can be viewed in the deferred tax liability provision. The buyer usually purchases the assets of the target with a base cost on capital gains tax.

4) Financial Assistance You will not be eligible for any financial help from the company whose shares you are trying to acquire. The companies act of 1985 prohibits a company purchasing a target company through a share acquisition from receiving any financing help from the company they are purchasing in the form of a loan. 5) Transfer restrictions There maybe some restrictions that applies during the acquisition to the transfer of the target company's articles of association or other outstanding contractual obligations that are in place which may then lead to complications with the acquisition of

Merger Process
What a Merger is Mergers are one of the main ways of concentrating businesses. There are two possible types of merger. The first is through the formation of a new company (NewCo) and at the same time the dissolution of the previous legal entities. The second is through the merger of one or more companies into another company, with the result that the participating companies retain their identities. The purpose of a merger is of an economic/industrial nature. The merger of two or more organizations allows for the generation of cost synergies (administration, production, and listing costs), as well as greater geographical coverage (with a positive impact on revenues and the possibility of further growth).

Steps in a Merger There are three major steps in a merger transaction: planning, resolution, implementation.

1. Planning, which is the most complex part of the merger process, entails the analysis, the action plan, and the negotiations between the parties involved. The planning stage may last any length of time, but once it is complete, the merger process is well on the way. More in detail, the planning stage also includes:
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signing of the letter of intent which starts off the negotiations; the appointing of advisors who play the role of consultants, examining the strengths, weaknesses, opportunities, and threats of the merger; detailing the timetable (deadline), conditions (share exchange ratio), and type of transaction (merger by integration or through the formation of a new company); expert report on the consistency of the share exchange ratio, for all of the companies involved.

2. The resolution is simply management's approval first, then by the shareholders involved in the merger plan. The resolution stage also includes:
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the Board of Directors calling an extraordinary shareholders meeting whose item on the agenda is the merger proposal; the extraordinary shareholders meeting being called to pass a resolution on the item on the agenda; any opposition to the merger by creditors and bondholders within 60 days of the resolution; green light from the Italian Antitrust Authority, that evaluates the impact of the merger and imposes any obligations as a prerequisite for approving the merger.

3. Implementation is the final stage of the merger process, including enrolment of the merger deed in the Company Register. Normally medium-sized/big mergers require one year from the start-up of negotiations to the closing of the transaction. This is because, in addition to the time needed technically, there are problems relating to the share exchange ratio between the merging companies which is rarely accepted by the parties without drawn-out negotiations. During the merger process, share prices will adjust to the share exchange ratio. On the effective date of the merger, financial intermediaries will enter the new shares with the new quantities in the dossiers. The shareholders may trade without constraint the new shares and benefit from all rights (dividends, voting rights).

HOSTILE ACQUISITIONS
The replacement of poor management is a potential source of gain from acquisition. Changing technological and competitive factors may lead to a need for corporate

restructuring. If incumbent management is unable to adapt, then a hostile acquisition is one method for accomplishing change. Hostile acquisitions generally involve poorly performing firms in mature industries, and occur when the board of directors of the target is opposed to the sale of the company. In this case, the acquiring firm has two options to proceed with the acquisitiona tender offer or a proxy fight. A tender offer represents an offer to buy the stock of the target firm either directly from the firm's shareholders or through the secondary market. In a proxy fight, the acquirer solicits the shareholders of the target firm in an attempt to obtain the right to vote their shares. The acquiring firm hopes to secure enough proxies to gain control of the board of directors and, in turn, replace the incumbent management. Management in target firms will typically resist takeover attempts, either to get a higher price for the firm or to protect their own self-interests. This can be done a number of ways. Target companies can decrease the likelihood of a takeover though charter amendments. With the staggered board technique, the board of directors is classified into three groups, with only one group elected each year. Thus, the suitor cannot obtain control of the board immediately even though it may have acquired a majority ownership of the target via a tender offer. Under a supermajority amendment, a higher percentage than 50 percentgenerally two-thirds or 80 percentis required to approve a merger. Other defensive tactics include poison pills and dual class recapitalizations. With poison pills, existing shareholders are issued rights that, if a bidder acquires a certain percentage of the outstanding shares, can be used to purchase additional shares at a bargain price, usually half the market price. Dual class recapitalizations distribute a new class of equity with superior voting rights. This enables the target firm's managers to obtain majority control even though they do not own a majority of the shares. Other preventive measures occur after an unsolicited offer is made to the target firm. The target may file suit against the bidder alleging violations of antitrust or securities laws. Alternatively, the target may engage in asset and liability restructuring to make it an unattractive target. With asset restructuring, the target purchases assets that the bidder does not want or that will create antitrust problems, or sells off the assets that the suitor desires to obtain. Liability restructuring maneuvers include issuing shares to a friendly third party to dilute the bidder's ownership position or leveraging up the firm through a leveraged recapitalization making it difficult for the suitor to finance the transaction. Other postoffer tactics involve targeted share repurchases (often termed "greenmail") in which the target repurchases the shares of an unfriendly suitor at a premium over the current market priceand golden parachutes, which are lucrative supplemental compensation packages for the target firm's management. These packages are activated in the case of a takeover and the subsequent resignations of the senior executives. Finally, the target may employ an exclusionary self-tender. With this tactic, the target firm offers to buy back its own stock at a premium from everyone except the bidder.

A privately held company is not subject to unfriendly takeovers. A publicly traded firm "goes private" when a group, usually involving existing management, buys up all the publicly held stock. Such transactions are typically structured as leveraged buyouts (LBOs). LBOs are financed primarily with debt secured by the assets of the target firm.

WHO BENEFITS FROM MERGERS AND ACQUISITIONS?

Mergers and acquisitions proceeded at a record pace during the late 1990s. Up until 1996, the most expensive corporate merger ever was the $25 billion deal between RJR Nabisco and Kohlberg Kravis Roberts that was completed in 1989. But this record has been surpassed numerous times since then. By the middle of 1998, the most expensive merger was the $78.2 billion deal between the Travelers Group and Citicorp. In fact, according to Jeff Rundles in Colorado Business, 8 of the 10 largest corporate mergers in history were announced during the first half of 1998. Some experts claimed that these enormous deals would reduce competition by creating highly consolidated industries controlled by a few major players. They argued that the huge corporations created by such mergers would focus on large accounts to the detriment of smaller customers. Individuals and small businesses would likely face higher prices and reduced services. There is also a question about whether stockholders gain from mergers and acquisitions. Empirical evidence suggests that the shareholders in acquired firms benefit substantially. Gains for this group typically amount to 20 percent in mergers and 30 percent in tender offers above the market prices prevailing a month prior to the merger announcement. The target company's stock price tends to rise following a merger announcement, while the acquiring company's stock price tends to remain flat. Therefore, the gains that accrue to acquiring firms are difficult to measure. The best evidence suggests that shareholders in bidding firms gain little. Losses in value subsequent to merger announcements are not unusual. This seems to suggest that overvaluation by bidding firms is common. Managers may also have incentives to increase firm size at the potential expense of shareholder wealth. If so, merger activity may happen for noneconomic reasons, to the detriment of shareholders.