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CHAPTER 21: MERGERS AND ACQUISITIONS

21-1. RATIONALE FOR MERGERS 21-4. HOSTILE VERSUS FRIENDLY TAKEOVERS
a) Synergy: • Acquiring Company: A company that seeks to acquire another firm.
• The primary motivation for most mergers is to increase the value of • Target Company: A firm that another company seeks to acquire.
the combined enterprise. • Once an acquiring company has identified a possible target, it must:
• Merger: The combination of two or more firms to form a single firm. 1. Establish a suitable price or range of prices
• Synergy: The condition wherein the whole is greater than the sum of 2. Tentatively set the terms of payment
its parts; in a synergistic merger, the post-merger value exceeds the 3. The acquiring firm's managers decide how to approach
sum of the separate companies‘ pre-merger values. the target company's managers.
Synergistic effects can arise from four sources: 4. It will propose a merger and try to work out suitable
1. Operating economies, which result from economies of scale in terms.
management, marketing, production, or distribution. 5. Two management groups will issue statements to their
2. Financial economies, including lower transactions costs and better stockholders indicating that they approve the merger.
coverage by security analysts. 6. The stockholders are asked to tender (or send in) their
3. Differential efficiency, which implies that the management of one shares to a designated financial institution, transferring
firm is more efficient and that the weaker firm's assets will be more ownership of the shares to the acquiring firm. The target
productive after the merger. firm's stockholders then receive the specified payment-
4. Increased market power due to reduced competition. Operating and common stock of the acquiring, cash, bonds, or some mix
financial economies are socially desirable, as are mergers that of cash and securities.
increase managerial efficiency; but mergers that reduce competition • Friendly Merger: A merger whose terms are approved by the
are socially undesirable and often illegal. managements of both companies.
b) Tax Considerations: • Hostile Merger: A merger in which the target firm's management
• A profitable firm in the highest tax bracket could acquire a firm with resists acquisition.
large accumulated tax losses. • Tender Offer: The offer of one firm to buy the stock of another by
• Mergers can serve as a way of minimizing taxes when disposing of going directly to the stockholders, frequently (but not always) over
excess cash. the opposition of the target company's management.
• Pay an extra dividend: stockholders have to pay
immediate taxes on the distribution. 21-5. MERGER ANALYSIS
• Invest in marketable securities: rates of return less than • The acquiring firm performs an analysis to value the target company.
those required by stockholders. • The target company should accept the offer if the price exceeds
• Repurchase its own stock: might result in a capital gain either its value if it continued to operate independently or the price
for the remaining stockholders. it could receive from some other bidder.
• Purchase another firm: using surplus cash to acquire a) Valuing the Target Firm:
another firm would avoid all these problems. 1. The target company does not continue to operate as a separate
c) Purchase of Assets Below Their Replacement Cost: entity but becomes part of the acquiring firm's portfolio of assets.
• Sometimes a firm will be touted as an acquisition candidate because So, changes in operations affect the value of the business and must
the cost of replacing its assets is considerably higher than its market be considered in the analysis.
value. 2. The goal of merger valuation is to value the target firm's equity
• For example: in the 1980s, several steel company executives stated because a firm is acquired from its owners, not from its creditors.
that it was cheaper to buy an existing steel company than to a) Valuing the Target Firm:
construct a new mill. 1. Discounted Cash Flow Analysis: valuing a business involves the
d) Diversification: application of capital budgeting procedures to an entire firm rather
• Managers often cite diversification as a reason for mergers as than to a single project.
diversification helps stabilize a firm's earnings and thus benefits its • Pro Forma Cash Flow Statements: Obtaining accurate
owners. post-merger cash flow forecasts
• But its value is less certain from the standpoint of stockholders. • In a pure financial merger, in which no
• Indeed, research of U.S. firms suggests that in most cases, synergies are expected, the incremental post-
diversification does not increase the firm's value. merger cash flows are simply the expected
e) Managers' Personal Incentives: cash flows of the target firm.
• Executive salaries are highly correlated with company size. This too • In an operating merger, where the two firms'
could play a role in corporate acquisition programs. operations are to be integrated, forecasting
• Personal considerations deter as well as motivate mergers. After future cash flows is more difficult.
most takeovers, some managers of the acquired companies lose • Unlike a typical capital budgeting analysis, a
their jobs-or at least their autonomy. Therefore, managers will merger analysis usually incorporates interest
lessen the chances of a takeover such as Mergers that enabled them expense into the cash flow forecast as debt
to retain power. associated with a merger is typically more
• Defensive Merger: A merger designed to make a company less complex than the single issue of new debt
vulnerable to a takeover. associated with a normal capital project.
f) Breakup Value: 1. Acquiring firms often assume the
• Breakup value: the value of the individual parts of the firm if they are debt of the target firm, so old debt
sold off separately. at different coupon rates is often
• If this value is higher than the firm's current market value, a takeover part of the deal
specialist could acquire the firm at or even above its current market 2. The acquisition is often financed
value, sell it off in pieces, and earn a substantial profit. partially by debt
3. if the subsidiary is to grow in the
21-2. TYPES OF MERGERS future, new debt must be issued
1. Horizontal Merger: A combination of two firms that produce the over time to support the expansion.
same type of good or service. 4. Therefore, the equity residual
2. Vertical Merger: A merger between a firm and one of its suppliers or method is used to value the target
customers. firm.
3. Congeneric Merger: A merger of firms in the same general industry, • Equity Residual Method:
but for which no customer or supplier relationship exists. 1. A method used to value a target
4. Conglomerate Merger: A merger of companies in totally different firm using cash flows that are
industries. residuals and belong solely to the

Getting a white knight who is acceptable to the target • The acquiring group expects to make a substantial profit from the firm's management to compete with the potential LBO. precise manner focusing on expected cash flows. The payments render the merger estimates should be discounted at infeasible the cost of equity. whether they are acquirers who need c) Post-Merger Control: capital to take over companies or target companies trying • The employment/control situation is often of vital interest in a to finance stock repurchase plans or other defenses merger analysis.A b) Developing Defensive Tactics: corporate alliance in which two or more independent • Target firms that do not want to be acquired generally enlist the help companies combine their resources to achieve a specific. 5. there is a debate as to whether mergers benefit the stockholders. where the free questionable value and a huge debt cash flows (which belong to all load. • Joint Venture is a one form of corporate alliance . purchase rights that allow them to • Estimating the Discount Rate: the cost of equity rather buy the stock of an acquiring firm than at the overall cost of capital is used. but the inherent risks are great due to the heavy use of acquirer. CORPORATE ALLIANCES 5. This is in contrast to the corporate leave the firm with new assets of valuation model. • Defenses include such tactics as: 1. Help finance mergers 21-8. power rather than shareholder will probably resist the merger. and so forth. market determined multiple to net income.718-719 package to clients. financial leverage. Raising antitrust issues • Leveraged Buyout (LBO): A situation in which a small group of 4. company if it is acquired by another: • Carve-Out: A minority interest in a corporate subsidiary is sold to • Borrowing on terms that require new shareholders. • Investment bankers identify firms with excess cash that might want • Alliances allow firms to create combinations that focus on to buy other firms. specific business lines that offer the most potential and firms that might be attractive to others. limited objective. Taking a poison pill: An action that seriously hurt a the parent company's stockholders. we cannot simply examine stock prices around 1. getting a white squire who is friendly to current a) Types of Divestitures: management to buy enough of the target firm's shares to • Divestiture: The sale of some of a company's operating assets. so the parent gains new equity financing yet immediate repayment of all loans if retains control. management be motivated by larger salaries. PRIVATE EQUITY INVESTMENTS simple majority is required to approve a merger • Not all target firms are acquired by publicly traded corporations but 2. acquiring firm's shareholders. merger and to recommend its acceptance to the • However. acquiring firm’s shareholders. synergies. 3. DO MERGERS CREATE VALUE? THE EMPIRICAL EVIDENCE • If the acquiring firm agrees to retain the old • Most researchers agree that takeovers increase the wealth of the management. sales. Help target companies develop and implement defensive tactics prices. However. at half price should the firm be • Valuing the Cash Flows: Use the discount rate above and acquired. of an investment banking firm. not just shareholders) • Giving its stockholders stock are discounted at the WACC. Trying to convince the target firm's stockholders that the by Private equity firms which raise capital from wealthy individuals price being offered is too low and look for opportunities to make profitable investments. • Corporate. against takeovers. the firm is acquired. • Planning defensive mergers that 2. Invest in the stocks of potential merger candidates. a merger. DIVESTITURES 6. 21-7. b) Developing Defensive Tactics: • Defenses include such tactics as: 21-10. it will • While the DCF method applies valuation concepts in a require a source of funds. market • To be successful in the mergers and acquisitions business. • Stock price movements can shed light on the issue of who gains from 21-6. an investment banker must be able to offer a financing b) Setting the Bid Price: Illustration p. • The acquired firm's managers will be worried about their post- merger positions. management may be willing to support the shareholders of target firms. calculate the present value of the cash flows c) Establishing a Fair Value: in most large mergers. earnings per d) Financing Mergers: share. Alliance: a) Arranging Merger: • A cooperative deal that stops short of a merger. multiple analysis is more judgmental. Managements of acquiring firms may • If the old management is to be removed. Market Multiple Analysis: investment banking firm to evaluate the target company and to help establish • A method of valuing a target company that applies a the fair price. Repurchasing stock in the open market to push the price investors (which usually includes the firm 's managers) borrows above that being offered heavily to buy all the shares of a company. 3. each side hires an 2. parachutes to their executives that the cash drain from these . • Dissident stockholders of firms with poor track records might work • These alliances take many forms. investors. block the merger • Spin-Off: A divestiture in which the stock of a subsidiary is given to 7. from simple marketing with investment bankers to oust management by helping to arrange agreements to joint ownership of worldwide operations. THE ROLE OF INVESTMENT BANKERS mergers. Changing the by-laws so that a supermajority versus a 21-9. or Strategic. • If the acquiring company has no excess cash. rather than as an operating entity. Help value target companies 4. • Liquidation: Occurs when the assets of a division are sold off • Granting such lucrative golden piecemeal. companies that might be willing to be bought. Help arrange mergers merger announcement dates because other factors influence stock 2. book value. wealth maximization.