CHAPTER 23 MERGERS AND ACQUISITIONS

Learning Objectives LO1 The different types of mergers and acquisitions, why they should (or shouldnt) take place, and the terminology associated with them. LO2 How accountants construct the combined balance sheet of a new company. LO3 Taxable ersus tax!free acquisitions. LO "ome financial side effects of mergers and acquisitions. LO! #ash ersus common stock financing in mergers and acquisitions. LO" How to estimate the $%& of a merger or an acquisition. LO# The gains from a merger or acquisition and how to alue the transaction. LO$ 'i estitures in ol ing equity car e!outs and spin!offs. Ans%ers t& C&nce'ts Revie% an( Critica) T*in+ing Q,esti&ns 1.LO1/ a. (reenmail refers to the practice of paying unwanted suitors who hold an equity stake in the firm a premium o er the market alue of their shares, to eliminate the potential takeo er threat. b. ) white knight refers to an outside bidder that a target firm brings in to acquire it, rescuing the firm from a takeo er by some other unwanted hostile bidder. c. ) golden parachute refers to lucrati e compensation and termination packages granted to management in the e ent the firm is acquired. d. The crown *ewels usually refer to the most aluable or prestigious assets of the firm, which in the e ent of a hostile takeo er attempt, the target sometimes threatens to sell. e. "hark repellent generally refers to any defensi e tactic employed by the firm to resist hostile takeo er attempts. f. ) corporate raider usually refers to a person or firm that speciali+es in the hostile takeo er of other firms. g. ) poison pill is an amendment to the corporate charter granting the shareholders the right to purchase shares at little or no cost in the e ent of a hostile takeo er, thus making the acquisition prohibiti ely expensi e for the hostile bidder. h. ) tender offer is the legal mechanism required by the exchange when a bidding firm goes directly to the shareholders of the target firm in an effort to purchase their shares. i. ) le eraged buyout refers to the purchase of the shares of a publicly!held company and its subsequent con ersion into a pri ately!held company, financed primarily with debt. .LO / 'i ersification doesnt create alue in and of itself because di ersification reduces unsystematic, not systematic, risk. )s discussed in the chapter on options, there is a more subtle issue as well. ,educing unsystematic risk benefits bondholders by making default less likely. Howe er, if a merger is done purely to di ersify (i.e., no operating synergy), then the $%& of the merger is +ero. -f the $%& is +ero, and the bondholders are better off, then stockholders must be worse off. .LO1/ ) firm might choose to split up because the newer, smaller firms may be better able to focus on their particular markets. Thus, re erse synergy is a possibility. )n added ad antage is that performance e aluation becomes much easier once the split is made because the new firms financial results (and stock prices) are no longer commingled.

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.LO1/ -t depends on how they are used. -f they are used to protect management, then they are not good for stockholders. -f they are used by management to negotiate the best possible terms of a merger, then they are good for stockholders. .LO3/ 1ne of the primary ad antages of a taxable merger is the write!up in the basis of the target firms assets, while one of the primary disad antages is the capital gains tax that is payable. The situation is the re erse for a tax!free merger. The basic determinant of tax status is whether or not the old stockholders will continue to participate in the new company, which is usually determined by whether they get any shares in the bidding firm. )n 231 is usually taxable because the acquiring group pays off the current stockholders in full, usually in cash.

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.LO#/ 4conomies of scale occur when a erage cost declines as output le els increase. ) merger in this particular case might make sense because 4astern and 5estern may need less total capital in estment to handle the peak power needs, thereby reducing a erage generation costs. .LO1/ )mong the defensi e tactics often employed by management are seeking white knights, threatening to sell the crown *ewels, appealing to regulatory agencies and the courts (if possible), and targeted share repurchases. 6requently, antitakeo er charter amendments are a ailable as well, such as poison pills, poison puts, golden parachutes, lockup agreements, and superma*ority amendments, but these require shareholder appro al, so they cant be immediately used if time is short. 5hile target firm shareholders may benefit from management acti ely fighting acquisition bids, in that it encourages higher bidding and may solicit bids from other parties as well, there is also the danger that such defensi e tactics will discourage potential bidders from seeking the firm in the first place, which harms the shareholders. .LO#/ -n a cash offer, it almost surely does not make sense. -n a stock offer, management may feel that one suitor is a better long!run in estment than the other, but this is only alid if the market is not efficient. -n general, the highest offer is the best one. .LO#/ &arious reasons include7 (0) )nticipated gains may be smaller than thought8 (.) 3idding firms are typically much larger, so any gains are spread thinly across shares8 (/) 9anagement may not be acting in the shareholders best interest with many acquisitions8 (:) #ompetition in the market for takeo ers may force prices for target firms up to the +ero $%& le el8 and (;) 9arket participants may ha e already discounted the gains from the merger before it is announced.

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11- .LO$/ )n equity car e!out is a type of di estiture wherein the parent firm creates an entirely new company through an -%1 and the new shareholders become the owners of the public company. -n a spin!off, the parent company distributes subsidiary shares to existing stockholders and no new equity is raised. -n a car e!out the parent is attempting to gain some alue from a business unit that does not necessarily fit into its strategic plan. -n a spin!off the parent is simply distancing itself from a subsidiary by transferring ownership to existing shareholders. 5hen 5endys sold a portion of Tim Hortons through a car e!out, it was able to raise new funds to finance other operations. The spin!off of )llstate by "ears made sense since "ears did not want to continue in the insurance business and di ested itself of its insurance di ision through this restructuring mechanism.

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S&),ti&ns t& Q,esti&ns an( 2r&b)e3s NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. ue to space and readability constraints! when these intermediate steps are included in this solutions manual! rounding may appear to have occurred. "owever! the final answer for each problem is found without rounding during any step in the problem. Basic 1.LO#/ 6or the merger to make economic sense, the acquirer must feel the acquisition will increase alue by at least the amount of the premium o er the market alue, so7 9inimum economic alue < =:0>,???,??? @ />A,???,??? < =:0,???,??? 2.LO#/ The maximum cash price per share for 'e onshire that should be paid is the existing share price plus the one!time benefit per share7 9aximum share price < =>? B (=0.?,???,??? C :,???,???) 9aximum share price < =D? 3.LO2/ a# "ince neither company has any debt, using the pooling method, the asset alue of the combined must equal the alue of the equity, so7 )ssets < 4quity < :?,???(=0:) B 0;,???(=:) < =A.?,??? b# 5ith the purchase accounting method, the assets of the combined firm will be the book alue of 6irm E, the acquiring company, plus the market alue of 6irm F, the target company, so7 )ssets from E < :?,???(=0:) < =;A?,??? (book alue) )ssets from F < 0;,???(=0>) < =.;;,??? (market alue) The purchase price of 6irm F is the number of shares outstanding times the sum of the current stock price per share plus the premium per share, so7 %urchase price of F < 0;,???(=0> B A) < =/:;,??? The goodwill created will be7 (oodwill < =/:;,??? @ .;;,??? < =D?,??? )nd the total asset of the combined company will be7 Total assets EF < Total equity EF < =;A?,??? B .;;,??? B D?,??? < =D?;,??? $% &o.! post'merger )ssets (oodwill Total =G0;,??? D?,??? =D?;,??? 4quity =D?;,??? =D?;,???

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.LO2/ -n the pooling method, all accounts of both companies are added together to total the accounts in the new company, so the post!merger balance sheet will be7 )mherst &o.! post'merger #urrent assets 6ixed assets Total =0;,:?? :.,:?? =;>,G?? #urrent liabilities 2ong!term debt 4quity = A,A?? 00,>?? /D,;?? =;>,G??

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.LO2/ "ince the acquisition is funded by long!term debt, the post!merger balance sheet will ha e long! term debt equal to the original long!term debt of )mhersts balance sheet, plus the original long!term debt on 4ssexs balance sheet, plus the new long!term debt issue, so7 %ost!merger long!term debt < =D,G?? B 0,D?? B 0A,??? < =.>,>?D (oodwill will be created since the acquisition price is greater than the book alue. The goodwill amount is equal to the purchase price minus the market alue of assets, plus the market alue of the acquired companys debt. (enerally, the market alue of current assets is equal to the book alue, so7 (oodwill < =0A,??? @ (=D,/?? market alue 6)) @ (=/,:?? market alue #)) B (=0,/?? B 0,D??) (oodwill < =A,;?? 4quity will remain the same as the pre!merger balance sheet of the acquiring firm. #urrent assets and debt accounts will be the sum of the two firms pre!merger balance sheet accounts, and the fixed assets will be the sum of the pre!merger fixed assets of the acquirer and the market alue of fixed assets of the target firm. The post!merger balance sheet will be7 Amherst &o.! post'merger #urrent assets 6ixed assets (oodwill Total =0;,:?? :;,/?? A,;?? =A>,.?? #urrent liabilities 2ong!term debt 4quity = A,A?? .>,>?? /.,D?? =A>,.??

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.LO2/ -n the pooling method, all accounts of both companies are added together to total the accounts in the new company, so the post!merger balance sheet will be7 (napps Enterprises! post'merger #urrent assets 1ther assets $et fixed assets Total = A,0?? 0,>0? ..,0?? =.D,D0? #urrent liabilities 2ong!term debt 4quity = :,0;? >,;?? 0G,.A? =..,D0?

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.LO2/ "ince the acquisition is funded by long!term debt, the post!merger balance sheet will ha e long! term debt equal to the original long!term debt of Hnapps balance sheet plus the new long!term debt issue, so7 %ost!merger long!term debt < =>,;?? B 0/??? < =.?,;?? 4quity will remain the same as the pre!merger balance sheet of the acquiring firm. #urrent assets, current liabilities, long!term debt, and other assets will be the sum of the two firms pre!merger balance

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sheet accounts, and the fixed assets will be the sum of the pre!merger fixed assets of the acquirer and the market alue of fixed assets of the target firm. $ote, in this case, the market alue and the book alue of fixed assets is the same. 5e can calculate the goodwill as the plug ariable which makes the balance sheet balance. The post!merger balance sheet will be7 (napp)s Enterprises! post'merger #urrent assets 1ther assets $et fixed assets (oodwill Total $= A,.?? 0,>0? .:,??? /,G:? =/;,A;? #urrent liabilities 2ong!term debt 4quity = :,0;? .?,;?? 00,??? =/;,A;?

.LO!/ a. The cash cost is the amount of cash offered, so the cash cost is =D; million. To calculate the cost of the stock offer, we first need to calculate the alue of the target to the acquirer. The alue of the target firm to the acquiring firm will be the market alue of the target plus the %& of the incremental cash flows generated by the target firm. The cash flows are a perpetuity, so &I < =:/,???,??? B =.,???,???C.0? < =A/,???,??? The cost of the stock offer is the percentage of the acquiring firm gi en up times the sum of the market alue of the acquiring firm and the alue of the target firm to the acquiring firm. "o, the equity cost will be7 4quity cost < .:?(=GD,???,??? B A/,???,???) < =A?,G??,??? b. The $%& of each offer is the alue of the target firm to the acquiring firm minus the cost of acquisition, so7 $%& cash < =A/,???,??? @ A0,???,??? < =0.,???,??? $%& stock < =A/,???,??? @ A?,G??,??? < =0.,.??,??? c. "ince the $%& is greater with the stock offer, the acquisition should be in stock.

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.LO1/ a. The 4%" of the combined company will be the sum of the earnings of both companies di ided by the shares in the combined company. "ince the stock offer is one share of the acquiring firm for three shares of the target firm, new shares in the acquiring firm will increase by one!third. "o, the new 4%" will be7 4%" < (=0G?,??? B G0?,???)CJ.0?,??? B (0C/)(D?,???)K < =:,0.; The market price of 'o er will remain unchanged if it is a +ero $%& acquisition. Lsing the %4 ratio, we find the current market price of 'o er stock, which is7 % < .0(=G0?,???)C.0?,??? < =G0 -f the acquisition has a +ero $%&, the stock price should remain unchanged. Therefore, the new %4 will be7 %C4 < =G0C=:.0.; < 0D.A:

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b. The alue of Tilbury to 'o er must be the market alue of the company since the $%& of the acquisition is +ero. Therefore, the alue is7 &I < =0G?,???(0/.;) < =.,:/?,??? The cost of the acquisition is the number of shares offered times the share price, so the cost is7 #ost < (0C/)(D?,???)(=G0) < =.,:/?.??? "o, the $%& of the acquisition is7 $%& < ? < &I B & @ #ost < =.,:/?.???B & @ .,:/?.??? & < =? )lthough there is no economic alue to the takeo er, it is possible that 'o er is moti ated to purchase Tilbury for other than financial reasons. 11.LO!/ a. The $%& of the merger is the market alue of the target firm, plus the alue of the synergy, minus the acquisition costs, so7 $%& < 0,;??(=0D) B =G,>?? @ 0,;??(=.0) < =;,>?? b. "ince the $%& goes directly to stockholders, the share price of the merged firm will be the market alue of the acquiring firm plus the $%& of the acquisition, di ided by the number of shares outstanding, so7 "hare price < J;,:??(=:>) B =;,>??KC;,:?? < =:G.?; c. The merger premium is the premium per share times the number of shares of the target firm outstanding, so the merger premium is7 9erger premium < 0,;??(=.0 @ 0D) < =/,??? d. The number of new shares will be the number of shares of the target times the exchange ratio, so7 $ew shares created < 0,;??(0C.) < >;? new shares The alue of the merged firm will be the market alue of the acquirer plus the market alue of the target plus the synergy benefits, so7 &3T < ;,:??(=:>) B 0,;??(=0D) B G,>?? < =.D0,??? The price per share of the merged firm will be the alue of the merged firm di ided by the total shares of the new firm, which is7 % < =.D0,???C(;,:?? B >;?) < =:>./0 e. The $%& of the acquisition using a share exchange is the market alue of the target firm plus synergy benefits, minus the cost. The cost is the alue per share of the merged firm times the number of shares offered to the target firm shareholders, so7 $%& < 0,;??(=0D) B =G,>?? @ >;?(=:>./0) < =0/,;:;

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Intermediate 11- .LO!/ The share offer is better for the target firm shareholders since they recei e only =.0 per share in cash . -n the share offer, the target firms shareholders will recei e7 4quity offer alue < (0C.)(=:>./0) < =./.A;; per share 6rom %roblem 0?, we know the alue of the merged firms assets will be =.D0,???. The number of shares in the new firm will be7 "hares in new firm < ;,:?? B 0,;??x that is, the number of shares outstanding in the bidding form, plus the number of shares outstanding in the target firm, times the exchange ratio. This means the post merger share price will be7 % < =.D0,???C(;,:?? B 0,;??x) To make the target firms shareholders indifferent, they must recei e the same wealth, so7 0,;??(x)% < 0,;??(=.0) This equation shows that the new offer is the shares outstanding in the target company times the exchange ratio times the new stock price. The alue under the cash offer is the shares outstanding times the cash offer price. "ol ing this equation for %, we find7 % < =.0 C x #ombining the two equations, we find7 =.D0,???C(;,:?? B 0,;??x) < =.0 C x x < .:/> There is a simpler solution that requires an economic understanding of the merger terms. -f the target firms shareholders are indifferent, the bidding firms shareholders are indifferent as well. That is, the offer is a +ero sum game. Lsing the new stock price produced by the cash deal, we find7 4xchange ratio < =.0C=:G.?; < .:/> 12.LO1/ The cost of the acquisition is7 #ost < .??(=:D) < =D,G?? "ince the stock price of the acquiring firm is =:/, the firm will ha e to gi e up7 "hares offered < =D,G??C=:/ < ..>.D?> shares (assuming $%& < ?) a. The 4%" of the merged firm will be the combined 4%" of the existing firms di ided by the new shares outstanding, so7 4%" < (=0,:?? B A??)C(0??? B ..>.D?>) < =0.A.GG b. The %4 of the acquiring firm is7 1riginal %C4 < =:/C(=0,:??C0???) < /?.>0: times )ssuming the %4 ratio does not change, the new stock price will be7

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$ew % < =0.A.GG(/?.>0:) < =;?.?/ c. -f the market correctly analy+es the earnings, the stock price will remain unchanged since this is a +ero $%& acquisition, so7 $ew %C4 < =:/C=0.A.GG < .;.:0 times d. The new share price will be the combined market alue of the two existing companies di ided by the number of shares outstanding in the merged company. "o7 % < J(0???)(=:/) B .??(=:>)KC(0??? B ..>.D?>) < =:..A>/ )nd the %4 ratio of the merged company will be7 %C4 < =:..A>C=0.A.GG < .A.0D times )t the proposed bid price, this is a negati e $%& acquisition for ) since the share price declines. They should re ise their bid downward until the $%& is +ero. 13- .LO"/ 3eginning with the fact that the $%& of a merger is the alue of the target minus the cost, we get7 $%& $%& $%& $%& < &3I @ #ost < & B &3 @ #ost < & @ (#ost @ &3) < & @ 9erger premium

1 - .LO"4 #/ a. The present alue of the merger gain is the alue of the perpetual sa ings7 %resent alue of merger gain < =G??,??? C .0: %resent alue of merger gain < =;,>0:,.G;.>0 b. The cost of the cash offer is the total price paid for shares7 #ost < =.; x .,;??,??? #ost < =A.,;??,??? c. The $%& of the offer is the %& of the merger gain plus the %& of the shares minus the cash cost7 $%& of cash offer < =0G x .,;??,??? B =;,>0:,.G;.>0 @ =A.,;??,??? < =;?,>0:,.G;.>0 @ =A..;9 $%& of cash offer < !=00,>G;,>0:..D 1!- .LO"4 #/ a. The synergy will be the present alue of the incremental cash flows of the proposed purchase. "ince the cash flows are perpetual, the synergy alue is7 "ynergy alue < =/;?,??? C .?G "ynergy alue < =:,/>;,??? b. The alue of Harwich to ,aleigh is the synergy plus the current market alue of Harwich, which is7 &alue < =:,/>;,???B D,???,??? &alue < =0/,/>;,???

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The alue of the cash option is the amount of cash paid, or =0. million. The alue of the stock acquisition is the percentage of ownership in the merged company, times the alue of the merged company, so7 "tock acquisition alue < ..;(=0/,/>;,??? B ./,???,???) "tock acquisition alue < =D,?D/,>;?

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The $%& is the alue of the acquisition minus the cost, so the $%& of each alternati e is7 $%& of cash offer < =0/,/>;,??? @ 0.,???,??? $%& of cash offer < =0,/>;,??? $%& of stock offer < =0/,/>;,??? @ D,?D/,>;? $%& of stock offer < =:,.G0,.;?

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The acquirer should make the stock offer since its $%& is greater.

1"- .LO!4 #/ a. The number of shares after the acquisition will be the current number of shares outstanding for the acquiring firm, plus the number of new shares created for the acquisition, which is7 $umber of shares after acquisition < ;,???,??? B 0,.??,??? $umber of shares after acquisition < A,.??,??? )nd the share price will be the alue of the combined company di ided by the shares outstanding, which will be7 $ew stock price < =0G;,???,??? C A,.??,??? $ew stock price < =.D.G/G>?DAG b. 2et equal the fraction of ownership for the target shareholders in the new firm. 5e can set the percentage of ownership in the new firm equal to the alue of the cash offer, so7 (=0G;,???,???) < =;?,???,??? < ..>?.> or .>.?.>M "o, the shareholders of the target firm would be equally as well off if they recei ed /? percent of the stock in the new company as if they recei ed the cash offer. The ownership percentage of the target firm shareholders in the new firm can be expressed as7 1wnership < $ew shares issued C ($ew shares issued B #urrent shares of acquiring firm) ..>?.> < $ew shares issued C ($ew shares issued B ;,???,???) $ew shares issued < 0,G;0,G:D./0 To find the exchange ratio, we di ide the new shares issued to the shareholders of the target firm by the existing number of shares in the target firm, so7 4xchange ratio < $ew shares C 4xisting shares in target firm 4xchange ratio < 0,G;0,G:D./0C .,???,??? 4xchange ratio < .D.;D )n exchange ratio of .D.;D shares of the merged company for each share of the target company owned would make the alue of the stock offer equi alent to the alue of the cash offer. Challenge

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.LO!4 "4 #/ a. To find the alue of the target to the acquirer, we need to find the share price with the new growth rate. 5e begin by finding the required return for shareholders of the target firm. The earnings per share of the target are7 4%"% < =A:?,???C0>;,??? < =/,A;> per share The price per share is7 %% < D..(=/.A;>) < =//.A:A )nd the di idends per share are7 '%"% < =/0?,???C0>;,??? < =0.>> The current required return for 1rford shareholders, which incorporates the risk of the company is7 ,4 < J=0.>>(0.?;)C= //.A:AK B .?; < .0?;. The price per share of %ulit+er with the new growth rate is7 %% < =0.>>(0.?>)C(.0?;. @ .?>) < =;/.G?/D>>.> The alue of the target firm to the acquiring firm is the number of shares outstanding times the price per share under the new growth rate assumptions, so7 &TI < 0>;,???(=;/.G?/D>>.>) < =D,:0;,ADA.?. b. The gain to the acquiring firm will be the alue of the target firm to the acquiring firm minus the market alue of the target, so7 (ain < =D,:0;,ADA.?. @ 0>;,???(=//.A:A) < =/,;.>,A:A.?. c. The $%& of the acquisition is the alue of the target firm to the acquiring firm minus the cost of the acquisition, so7 $%& < =D,:0;,ADA.?. @ 0>;,???(=/G) < =.,>A;,ADA.?. d. The most the acquiring firm should be willing to pay per share is the offer price per share plus the $%& per share, so7 9aximum bid price < =/G B (=.,>A;,ADA.?.C0>;,???) < =;/.G?/D>>.> $otice, this is the same alue we calculated earlier in part a as the alue of the target to the acquirer. e. The price of the stock in the merged firm would be the market alue of the acquiring firm plus the alue of the target to the acquirer, di ided by the number of shares in the merged firm, so7 %6% < (=;A,;;?,??? B D,:0;,ADA.?.)C(0,/??,??? B 0??,???) < =:>.00G/;:/ The $%& of the stock offer is the alue of the target to the acquirer minus the alue offered to the target shareholders. The alue offered to the target shareholders is the stock price of the merged firm times the number of shares offered, so7

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$%& < =D,:0;,ADA.?. @ 0??,???(=:>.00G/;:/) < =:,>?/,GA?.;D f. Fes, the acquisition should go forward, and ,idgetown should offer the 0??,??? shares since the $%& is higher. g. Lsing the new growth rate in the di idend growth model, along with the di idend and required return we calculated earlier, the price of the target under these assumptions is7 %% < =0.>>(0.?A)C(.0?;. @ .?A) < =:0.;?GG:D;A )nd the alue of the target firm to the acquiring firm is7 &%I < 0>;,???(=:0.;?GG:D;A) < =>,.A:,?:G.A> The gain to the acquiring firm will be7 (ain < =>,.A:,?:G.A>@ 0>;,???(=//.A:A) < =0,/>;,DDG.A> The $%& of the cash offer is now7 $%& cash < =>,.A:,?:G.A>@ 0>;,???(=/G) < =A0:,?:G.A> )nd the new price per share of the merged firm will be7 %6% < J=;A,;;?,??? B >,.A:,?:G.A>KC(0,/??,??? B 0??,???) < =:;.;G0:A//: )nd the $%& of the stock offer under the new assumption will be7 $%& stock < =>,.A:,?:G.A>@ 0??,???(=//.:;) < =.,>?;,D?../: 4 en with the lower pro*ected growth rate, the stock offer still has a positi e $%&. ,idgetown should pursue the purchase 1rford with a stock offer of 0??,??? shares.

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