Chapter 17 Mergers and Acquisitions

Mergers and Acquisitions

Merger – a combination of two or
more businesses under one
ownership
Acquisition or Takeover - one firm
acquires the stock of another
– Acquired firm is the target
Consolidation - combining firms
dissolve forming a new legal entity
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Figure 17-1 Basic Business Combinations

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 Mergers and Acquisitions
Relationships
– Consolidation implies the firms
combined willingly
– Acquisition can be a friendly or hostile
takeover
Stockholders
– Must be willing to give up their shares
for the offered price
– Approval from majority necessary for
acquisition to be successful

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 Mergers and Acquisitions
Friendly Procedure Unfriendly Procedure
– Target firm's – Target firm's
management management resists,
approves and takes defensive
cooperates with measures to stop
acquiring company takeover
– Negotiation occurs – Acquiring firm
until agreement is makes a tender offer
reached to the target's
– Proposal shareholders
submitted for
stockholder vote

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 Why Unfriendly Mergers
are Unfriendly
A target's management may resist a
takeover because:
– Acquiring firm offered too low a price for
the stock
– Target’s management often loses jobs,
power, and influence

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 Economic Classification of
Business Combinations
Vertical Merger
– Acquiring suppliers of customers
Horizontal Merger
– Merging firms are competitors
Congeneric Merger
– Firms are in related but not competing
businesses
Conglomerate Merger
– Firms are in entirely different fields

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 A Further Classification

Strategic Merger
– Merger is undertaken to enhance
the acquirer’s business position
Financial Merger
– Merger is undertaken to make
money from the merger process
 Role of Investment Banks
Help companies issue securities
Instrumental in acting as advisors to
acquiring companies
Assist in establishing a value for target
Help acquiring firm raise money for
acquisition
Advise reluctant targets on defensive
measures

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 The Antitrust Laws
U.S. is committed to a competitive
economy
Antitrust laws (enacted 1890 - 1930s)
prohibit certain activities that can
reduce competitive nature of the
economy
Mergers have potential to reduce
competition

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The Reasons Behind Mergers
Synergies
– Combined performance is expected to be better
than the sum of the separate performances
– Usually cost saving or marketing opportunities
Growth
– External growth through acquisition is faster
than internal growth
Diversification to Reduce Risk
– Collection of diverse businesses less risky than
a single line
– Variations in different business lines offset each
other

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 The Reasons Behind Mergers

Economies of Scale
Guaranteed Sources and Markets
Acquiring Assets Cheaply
Tax Losses
Ego and Empire

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 Tax Losses

Rich Inc. Poor Inc. Merged

EBT $2,000 ($1,000) $1,000
Tax (35%) 700 -0- 350
Net Income $1,400 ($1,000) $650

Combined Businesses pay less total tax.

But IRS will not recognize if sole purpose is to reduce tax.

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 Holding Companies
Corporation that owns other corporations
– Companies owned are subsidiaries
– Holding company is the parent of the subsidiary
Advantages
– Keeps business operations separate and
distinct
– Can keep liabilities of subsidiaries separate
– It’s possible to control a subsidiary without
owning all of its stock

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 The History of Merger
Activity in the U.S.
Wave 1: The Turn of the Century, 1897-1904
– Horizontal mergers transformed the U.S.
into a nation of industrial giants, with some
monopolies
Wave 2: The Roaring Twenties, 1916-1929
– Began with World War I and ended with the
stock market crash of 1929
– Horizontal mergers led to oligopolies

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 The History of Merger
Activity in the U.S.
Wave 3: The Swinging Sixties, 1965-1969
– Conglomerate mergers - unrelated fields
– Stock market driven

An Important Development During the 1970s

– Hostile takeovers uncommon prior to 1970s
– 1974 INCO acquires ESB assisted by respected
investment bank Morgan Stanley
– After that hostile takeovers became acceptable

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 The History of Merger
Activity in the U.S.
Wave 4: Megamergers, 1981 – 1990
– Very large firms, often industry leaders, merge

Wave 5: Globalization, 1992 – 2000

– Began after 1991 – 1992 recession
– Large number of international mergers
– Ended with September 11, 2001

Wave 6: Private Equity, 2003 – 2008

– Private equity groups bought companies for
financial reasons
– Ended with the financial crisis of 2008

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 Mergers since the 1980s
Mergers since the 1980s are
characterized by:
Large Size
Global
Horizontal mergers and antitrust
Easy financing
Hostility
Raiders
Defenses
Advisors
 Megamergers since the 1980s

Companies Year Industry $ Size

Citicorp and Travelers 1988 Financial Services $140 billion
MCI and WorldCom 1998 Telecom $ 37 billion
Daimler-Benz and Chrysler 1998 Automotive $ 75 billion
AOL and Time Warner 2000 Media and Entertainment $ 350 billion
Hewlett-Packard and Compaq 2001 Computer hardware $ 25 billion
 Social, Economic, and
Political Effects
Large mergers have implications
regarding the concentration of power
and influence
– Anti-competitiveness of merging large
companies
– Concentrates economic power in the
hands of a few

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 Merger Analysis and the
Price Premium

What is the most an acquiring

company should pay for a target in
total and per share?
– Merger analysis attempts to answer this
question
– Acquiring firm forecasts the target's
cash flows and chooses appropriate
discount rate

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 Merger Analysis and the
Price Premium
Estimating Merger Cash Flows
– Should be a straightforward cash flow
estimation with two exceptions
Adjustments for expected synergies
Adjustments for reinvestment necessary to
support growth
– Pitfalls of estimating cash flows
May not have access to the target's detailed
information about future prospects or the past
Uncertainty of future
Biases of people making estimates
– Acquirer tends to overestimate target’s
value

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 Merger Analysis
Appropriate Discount Rate
– An acquisition is an equity transaction
– Use target’s estimated equity rate (CAPM)
Value to the Acquirer is the PV of estimated
cash flows from target
– Maximum value makes NPV=0 if viewed in
capital budgeting terms
Payment for target’s stock is C0 – the initial outlay
Maximum Per-share Price is Maximum
PV ÷ number shares

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 Merger Analysis and the
Price Premium
Price Premium
– The price offered to target shareholders
must be higher than the stock's market
price
High enough to induce stockholders to sell
now
Offering price exceeds the current market
price by the price premium

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 The Price Premium
Effect on market price
– Certainty of a premium creates a
speculative opportunity
– Investor strategy - buy stock in potential
takeover targets to get premium
– Size of Premium is the Point of
negotiations
Remember: Insider trading illegal

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Calculating a Price and the Problem of
Terminal Values
Remember

In merger analysis, C0 is the amount acquirer

will pay for the target’s stock
If the merger is to make sense for the acquirer,
C0 must be no more than the sum of the PVs
of all the other Cs
The maximum price makes NPV=0

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 Concept Connection Example 17-1
Basic Merger Analysis
Alpha is interested in acquiring Beta. The appropriate interest
rate for the analysis is 12%.
Beta’s cash flows including synergies are estimated for the
next three years as follows ($000).

Beta has 12,000 shares of stock outstanding

What is the maximum price Alpha should be willing to pay for

a share of Beta’s stock?

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 Concept Connection Example 17-1
Basic Merger Analysis
Solution: T he PV of Beta’s cash flows is:

The maximum Alpha should pay for all of Beta’s stock is $531,914.

the maximum per share price Alpha should be willing to pay is:

Maximum acquisition price = $531,914/12,000 = $44.33

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Merger Analysis with Terminal Values
Justifying a merger based on a few
years of cash flows can be difficult
Acquisition looks better by assuming
cash flows after the last year. E.g.
– Sale of the target at a high price
– Continuing operating cash flows for a
long time or indefinitely
Constant
Growing
Such assumptions are terminal values
over
 Terminal Values (TVs)
TVs can overwhelm detailed forecast.
– Especially an infinite stream of income
TV is valued as the PV of a perpetuity
starting at end of detailed forecast.
– TVs are favored by people who want the
acquisition for non financial reasons
– It’s up to Finance (CFO) to keep the
assumptions reasonable
Terminal Value assumptions often
lead to overpaying for an acquisition
 Paying for the Acquisition
The Junk Bond Market
Acquiring firm pays the target firm:
– Cash – have it or raise it
– Stock in the acquiring firm
– Debt of the acquiring firm
Junk bond market began in the 1980s
and has helped firms raise cash to
finance many mergers

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 Paying for the Acquisition
The Junk Bond Market
Junk bonds are low quality (risky) bonds
that pay high yields
Prior to 1980s small, risky companies could
not borrow via bonds
– Investment bankers pooled risky bonds
into funds creating the junk bond market
– The idea collapsed in the late 1980s
Since 1990’s, high yield debt has
reemerged

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The Capital Structure Argument to
Justify High Premiums
Using debt to raise cash for buying out a
target's stockholders, makes the firm more
leveraged
– It can be argued that this increases its value
See Chapter 14 on capital structure and leverage -
The Effect of Paying Too Much
– An acquiring firm that pays too much for
a target transfers value from its
shareholders to the target’s
shareholders
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 Defensive Tactics:
After a Takeover is Underway
Defensive Tactics are things targets
do to keep from being acquired
Tactics After a Takeover is Under Way
– Challenge the price
– Claim an antitrust violation
– Issue debt and repurchase shares
– Seek a white knight
– Greenmail

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 Defensive Tactics:
In Anticipation of a Takeover
Tactics in Anticipation of a Takeover
– Staggered Election of Directors
– Approval by a supermajority
– Poison pills
– Golden parachutes
– Accelerated debt
– Share rights plans

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 Leveraged Buyouts (LBOs)
Investors take a company private by
buying all of its stock largely using
borrowed money
– Then attempts to work down the debt
Tends to be risky due to high debt
burden
Less common today than in the 1980s

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 Proxy Fights
Proxy - a legal document giving one
person the right to act for another on
a certain issue

Proxy fight - opposing groups solicit

shareholders’ proxies to elect
directors

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 Divestitures

A company decides to get rid of a

particular business operation
– Reasons for divestitures
A firm needs cash
A division may not fit strategically into
the firm's long-term plans
Poor performance

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 Divestitures
Methods of Divesting Companies
– Sale for cash and/or securities
– Spin-off —creates a new company
owned by the same stockholders, can
trade separately
– Liquidation —the divested business is
closed down and its assets sold

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 Failure and Insolvency
Economic failure —a firm is unable to
provide adequate return to its stockholders

Commercial failure —a business cannot

pay its debts (insolvent)

A business can be an economic failure

without being a commercial failure

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 Bankruptcy
Concept and Objectives
Bankruptcy – protects a failing firm
from creditors until a resolution is
reached to close or continue it
Bankruptcy court protects a firm from
its creditors and determines whether
it should shut down or continue
– Liquidation
– Reorganization

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Bankruptcy Procedures—Reorganization,
Restructuring, Liquidation
Reorganize Liquidate
Insolvent company Insolvent company
perceived as deemed unrecoverable
recoverable will will liquidate
reorganize
Assets will be sold
Debt will be under the court's
restructured and a
plan developed to supervision, with
pay creditors as proceeds to pay
fairly as possible creditors according to
priority

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Bankruptcy Procedures—Reorganization,
Restructuring, Liquidation

Bankruptcy petition can be initiated

– voluntarily by insolvent company or
– involuntarily by its creditors

A firm in bankruptcy is usually allowed to

continue operations
– Trustee oversees the firm’s operations to
protect the interests of its creditors

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 Reorganization
A plan under which an insolvent firm continues to
operate while attempting to pay off its debts
Reorganization plans are judged on fairness and
feasibility
– Fairness—claims are satisfied based on
priorities
– Feasibility—likelihood the plan will actually
work
Plan must be approved by the bankruptcy court,
firm's creditors and stockholders

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 Debt Restructuring
Involves concessions that lower an
insolvent firm’s payments so it can
continue to operate
Can be accomplished in two ways:
– Extension
– Composition
Creditors have an incentive to compromise
because if the firm fails they are likely to
receive even less

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 Debt Restructuring
Debt-to-equity conversions are a
common method of restructuring debt
– Creditors give up debt claims in return
for stock in the company
– Equity may be worth more in the long
run than the debt given up

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 Concept Connection Example 17-4
Debt Restructuring in Bankruptcy
Adcock has 50,000 shares of common stock outstanding at a book value
of $40, pays 10% interest on its debt, and is in the following financial
situation

Income and Cash Flow Capital

EBIT $200 Debt $6,000
Interest 600 Equity 2,000
EBT ($400) Total capital $8,000
Tax --- Notice that although the company has
positive EBIT, it doesn't earn enough
Net Income ($400) to pay its interest let alone repay
principal on schedule. Without help
Depreciation 200 of some kind it will fail shortly. Devise
a composition involving a debt for
Principal Repayment (100) equity conversion that will keep the
firm afloat.
Cash flows ($300)

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 Concept Connection Example 17-4
Debt Restructuring in Bankruptcy
Suppose creditors are willing to convert $3 million in debt to equity at the
$40 book value. Requires issuing 75,000 new shares, resulting in the
following financial situation.

Income and Cash Flow Capital

EBIT $200 Debt $3,000
Interest 300 Equity 5,000
EBT ($100) Total capital $8,000
Tax ---
Notice that the company now
Net Income ($100) has a slightly positive cash
flow and can at least
Depreciation 200 theoretically continue in
Principal Repayment (50) business indefinitely.
However, creditors now own a
Cash flows ($50) controlling interest in the firm.

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 Liquidation
Closing a troubled firm and selling its assets

Trustee attempts to recover any unauthorized

transfers out of the firm

Trustee supervises the sale of the assets, pools

and distributes the funds

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 Liquidation
Claimants include
– Vendors - who sold to the firm on credit
– Employees – who are owed wages
– Customers - deposits for merchandise
– Government - owed taxes
– Lawyers and the court
– Stockholders - receive whatever is left

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 Distribution Priorities
Bankruptcy code contains priorities for the distribution
of assets among claimants
Priority code payoffs of unsecured claimants:
– Administrative expenses of the bankruptcy proceedings
– Certain business expenses incurred after the bankruptcy
petition is filed
– Certain unpaid wages
– Certain unpaid contributions to employee benefit plans
– Certain customer deposits
– Unpaid taxes
– Unsecured creditors
– Preferred stockholders
– Common stockholders

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Bankruptcy Code Chapters
Chapter 7
– Liquidation
Chapter 11
– Reorganization
Notice that Bankruptcy is a Federal
court procedure, not state
– Although some state laws do apply

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