Mergers

&
Acquisitions
Introduction
Another firm should be acquired only if
doing so generates a positive NPV.
However, the NPV of an acquisition
candidate can be difficult to determine.
As such, acquisitions are an investment
made under uncertainty.
Introduction
Historically, there are distinct,
systematic patterns to the returns
various security-holder classes earn
during corporate control transactions
(mergers and acquisitions).
The strongest and most consistent
regularity is that the target firm
shareholders earn large, positive
abnormal returns in virtually all
transactions, while bidder shareholder
results are mixed.
Introduction
Target shareholder returns are larger:
2. For leveraged buyouts (by incumbent
management) than external
takeovers.
3. In contested bids than single bidder
transactions.
4. In recent years than during the 1960s.
Introduction
Bidder shareholder returns are more mixed,
in that:
2. Bidder shareholders earned
significantly positive abnormal returns
during the 1960s, but these have
decreased over time.
3. Bidding firm shareholders on average
break even in those takeovers where
cash is used, but lose when stock is
the form of payment.
4. Bidder shareholders lose when their
Legal Forms Of Acquisitions
1. Acquisitions through Merger or
Consolidation
Merger - the complete absorption of one firm
by another; after the merger, the acquired
firm ceases to exist as a separate business
entity.
Consolidation - is the same as a merger
except a new firm is created; after the
merger, both the acquiring firm and the
acquired firm terminate their previous legal
existence and became part of a new firm.
Legal Forms Of Acquisitions
1. Acquisition of Stock
A second way to acquire another firm is to simply
purchase the firm’s voting stock in exchange for
cash, shares of stock, or other securities.
A tender offer (ie. public offer to buy shares) is
made by one firm directly to the shareholders of
another firm.
If the shareholders choose to accept the offer,
they tender their shares by exchanging them for
cash or securities (or both), depending on the
offer.
A tender offer is usually contingent on the
bidder’s obtaining some percentage of the total
Legal Forms Of Acquisitions
1. Acquisition of Assets
A firm can effectively acquire another firm by
buying most or all of the assets.
However, the target firm does not necessarily
cease to exist unless its shareholders choose
to dissolve it.
This type of acquisition requires a formal vote
of the shareholders of the selling firm.
The acquisition may involve transferring titles
to individual assets, a legal process that can
be costly.
Legal Forms Of Acquisitions
A Note on Takeovers
A takeover occurs when one group takes
control from another. Three forms include:
3. Acquisitions (merger or consolidation) –
occurs when the bidding firm makes a tender
offer or acquires the assets of the target firm.
4. Proxy contest – occurs when a group
attempts to gain controlling seats on the B of
D by voting in new directors.
5. Going private – all the equity shares of a
public firm are purchased by a small group of
investors through a leveraged buyout (LBO).
The shares are then delisted from stock
exchanges.
Legal Forms Of Acquisitions

A Note on Takeovers
Merger or
consolidation

Acquisition
Acquisition of stock

Takeovers Proxy contest Acquisition of assets

Going private
Taxes And Acquisitions
If one firm buys another firm, the transaction may
be taxable or tax-free.
In a taxable acquisition, the shareholders of the
target firm are considered to have sold their
shares and they have capital gains or losses that
are taxed; it is a taxable acquisition if the buying
firm offers the selling firm cash for its equity.
In a tax-free acquisition, since the acquisition is
considered an exchange rather than a sale, no
capital gain or loss occurs at that time; the
general requirements for tax-free status are that
the acquisition involves 2 corporations from same
country, subject to same corporate tax and that
there be a continuity of equity interest.
Taxes And Acquisitions
In addition, there are two tax-related factors
to consider when comparing acquisition
alternatives:
2. The capital gains effect – in a taxable
acquisition, shareholders may demand a
higher price as compensation, thereby
increasing the cost of the merger.
3. The write-up effect – in a taxable acquisition,
the assets of the selling firm are revalued or
“written-up” from their historic book value to
their estimated current market value.
Gains From Acquisitions
Acquiring another firm makes sense only if
there is some concrete reason to believe the
target firm is somehow worth more in our
hands than it is worth now. Some reasons
include:

3. Synergy
“The whole is worth more than the parts.”
Synergy is measured as the difference
between the value of the combined firm
and the sum of the values of the firms as
separate entities – it is the incremental net
gain from the acquisition.
Gains From Acquisitions
1. Revenue Enhancement
Marketing gains: improved promotion,
distribution and/or product mix; cross-
marketing.
Strategic benefits: enhances management
flexibility with regard to the company’s future
operations – the process of entering a new
industry to exploit perceived opportunities.
Market power: increased market share and
market power – profits can be enhanced
through higher prices and reduced
competition.
Gains From Acquisitions
1. Cost Reductions
Economics of scale: the sharing of central
facilities spreads fixed overhead more thinly.
Economics of vertical integration: makes
coordinating closely related activities easier.
Complementary resources: to make better
use of existing resources or to provide the
missing ingredient for success.
Gains From Acquisitions
1. Tax Gains
Net operating losses: the combined firm
would have a lower tax bill than the two firms
considered separately.
Unused debt capacity: adding debt can
provide important tax savings and many
acquisitions are financed using debt.
Surplus funds: the tax problem associated
with paying dividends is avoided.
Asset write-ups: in a taxable acquisition, the
assets of the acquired firm can be revalued.
Gains From Acquisitions
1. Changing Capital Requirements
All firms must make investments in working
capital and fixed assets to sustain an
efficient level of operating activity.
A merger may reduce the combined
investments needed by the two firms.
For example, a firm that is producing at
capacity can either build new or merge with
a firm that has excess capacity.
Gains From Acquisitions
1. Inefficient Management
There are firms whose value could be
increased with a change in management.
These firms are poorly run or otherwise do
not efficiently use their assets to create
shareholder wealth.
Gains From Acquisitions
1. Going Global
Entering new markets may be more viable
buying existing operations and infrastructure
in the foreign country.
Government restrictions, consumer
confidence in foreigners, and entry barriers
play key roles in foreign market expansion
decision-making.
Gains From Acquisitions
Some general rules in evaluating an
acquisition are:
1. Do not ignore market values.
2. Estimate only incremental cash flows to
your firm.
3. Use the correct risk-adjusted cost of
capital.
4. Be aware of transaction costs including
merger implementation costs.
5. Understand corporate culture and the
impacts this will have on the “marriage”.
Myths of Acquisitions
Diversification
Diversification is commonly mentioned as a
benefit to a merger – it reduces unsystematic
risk.
However, given the value of an asset depends
on only its systematic risk, shareholders will
not pay a premium for a merged company just
for the benefit of diversification.
Stockholders can get all the diversification
they want simply by buying stock in different
companies.
Myths of Acquisitions
EPS Growth
An acquisition can create the appearance of
growth in EPS.
This may fool investors into thinking the firm is
doing better than it really is.
Astute financial managers will look beyond the
accounting numbers in valuing the net impacts
of an acquisition.
The Cost of an Acquisition (Cash or Common Stock)

All other things being the same, if

common stock is used, the acquisition
cost may be higher because the target
firm’s shareholders must share the
acquisition gains with the shareholders
of the bidding firm.
If cash is used, the cost of an acquisition
may not depend on the acquisition
gains.
The Cost of an Acquisition (Cash or Common Stock)

Whether to finance an acquisition

by cash or by shares of stock
depends on several factors,
including:
1. sharing gains
2. taxes
3. control
Corporate Raiders
While most would agree that corporate raiders
can deliver benefits to shareholders and
society, there is increasing concern over
whether the cost is too high.
That is, when plants close or move, workers
and equipment can be turned to other uses
only at a cost to society – usually paid for by
taxpayers.
In addition, critics argue that they reduce trust
between management and labor thus reducing
efficiency and increasing costs.
Corporate raider – usually refers to the person
or firm that specializes in the hostile takeover
Defensive Tactics
Target firms frequently resist takeover attempts;
resistance usually starts with press releases and
mailings to shareholders presenting management’s
viewpoint.
It can eventually lead to legal action and
solicitation of competing bids.
Managerial action to defeat a takeover attempt
may make target shareholders better off if it elicits
a higher offer premium from the bidding firm or
another firm.
However, management resistance may simply
reflect pursuit of self-interest at the expense of
shareholders.
Defensive Tactics
The Control Block and the Corporate
Charter
If an individual or group owns 51% of a
company’s common stock, this control block
makes a hostile takeover virtually impossible.
The corporate charter refers to the articles of
incorporation and corporate by-laws that
establish the governance rules of the firm.
Firms can amend their charter to make
acquisitions more difficult by, for example,
requiring a merger to be approved by 80% of
the shareholders of record.
Defensive Tactics
Repurchase/Standstill Agreements
Standstill agreements are contracts where the
bidding firm (or individual) agrees to limit its
holdings in the target firm; these agreements
usually lead to the end of the takeover attempt.
Standstill agreements often occur at the same
time that a targeted repurchase is arranged.
In a targeted repurchase, a firm buys a certain
amount of its own stock from unwanted
investor(s), usually at a substantial premium
(known as greenmail).
These premiums can be thought of as payments
to potential bidders to eliminate unfriendly
takeover attempts.
Defensive Tactics
Greenmail – refers to the practice of
paying unwanted suitors who hold an
equity stake in the firm a premium for
their shares over the market value, to
eliminate the potential takeover threat.
Defensive Tactics
Poison Pills and Share Rights Plans
A poison pill is a financial device designed to
make unfriendly takeover attempts unappealing
if not impossible.
A share rights plan, a type of poison pill, are
provisions allowing existing stockholders to
purchase stock at some fixed price should an
outside takeover bid take place, discouraging
hostile takeover attempts.
Defensive Tactics
Poison Pill – is an amendment to the
corporate charter granting the
shareholders the right to purchase
shares at little or no cost in the event of
a hostile takeover, thus making the
acquisition prohibitively expensive for
the hostile bidder.
Defensive Tactics
Going Private and Leveraged Buyouts
In a sense, a LBO can be a takeover defense.
However, it is only a defense for management.
From the stockholder’s point of view, a LBO is a
takeover because they are bought out.
In a LBO, the selling shareholders are paid a
premium on the market price of their stock, just
as they are in a acquisition.
Defensive Tactics
Does a LBO create value?
There are generally two reasons given
for the ability of a LBO to create value:
3. The extra debt creates a tax deduction
which (may) lead to an increase in firm
value.
4. The LBO usually turns the previous
managers into owners, thereby
increasing their incentive to work hard.
Defensive Tactics
Since the mid-1980s, ongoing
experience with LBOs has revealed
some weaknesses both in the concept
and the financing vehicle – high-yield
junk bonds.
Further, LBOs sometimes lead to
spinoffs of assets to pay down debt.
Defensive Tactics
Other Defensive Tactics
b. Golden Parachutes
Some target firms provide compensation to
top-level management if a takeover
occurs.
This can be viewed as a payment to
management to make it less concerned for
its own welfare and more interested in the
shareholders who are considering the bid.
Defensive Tactics
a. Crown jewels
Firms sometimes sell major assets when
faced with a takeover threat.
b. White knight
Target firms sometimes seek a competing
bid from a friendly bidder who promises to
maintain the jobs of existing management
and to refrain from selling the target firm’s
assets.
In-Conclusion
Shareholders of successful target
firms achieve substantial gains as a
result of a takeover.
Shareholders of bidding firms earn
significantly less from takeovers.
In fact, studies have found that the
acquiring firms actually lose value in
many mergers.
In-Conclusion
Rules of thumb for merger success?
Don’t rush the wedding - do your homework
carefully to prevent morning-after surprises.
Know what you’re buying - not just the
financials, but the corporate culture.
Adopt each partner’s best practices - don’t
assume the bigger company or the acquirer
has all the answers.
Be honest with employees about how a merger
will affect them - start early and communicate
honestly with them.
Take the time to do internal recruiting - make
sure the managers you want to keep don’t go
wandering off to a competitor.