Mergers and Acquisitions

Mergers and Acquisitions
Vs Strategic Alliances
by
Dr. Glen Brown
Executive Summary
1 Mergers versus Alliances
1.1 Alliances with growing
1.2 Leveraging Rewards while lowering risks
1.3 Rules of the road.
2 ARGUMENTS FOR AND AGAINST MERGERS AND ACQUISITIONS
2.1 Methods of amalgamations and takeovers
2.2 Rationale for growth by acquisition
2.2.1 Application #1.
2.3 Sources of synergy
2.3.1 synergy from operating economies
2.4 Financial synergy
2.4.2 Application #3
3 Other synergistic effects
4 Why a company may want to be acquired
5 Gains from mergers
6 Causes of failure
7 Conclusions on growth by acquisition
8 Merger and acquisition activity in different countries
9 STRATEGIES AND TACTICS OF MERGERS AND ACQUISITIONS
9.1 Strategic steps
9.2 Tactical steps
10 IDENTIFYING POSSIBLE ACQUISITION TARGETS
10.1 Information required for appraisal of acquisitions
11 ACQUISITION CONSIDERATION AND STRUCTURE
11.1 Share or asset purchase
11.2 Financial value
12 ACQUISITION OF QUOTED COMPANIES
12.1 The regulation of takeovers
12.2 Procedure for a public bid — preliminary steps
13 City Code regulation of acquisitions
13.1 The stages of an offer
14 ACQUISITION OF PRIVATE COMPANIES
14.1 Preliminary considerations
14.2 Documentation of the agreement
15 DEFENCE AGAINST TAKEOVERS
15.1 Management attitude to a bid
15.2 Non-financial considerations
15.3 Reasons for predatory bids
16 Strategic defense
17 Good housekeeping
18 The reaction of the target company
19 Anti-takeover mechanisms
20 Defense document
21 Acceptable offers
22 ISSUES INFLUENCING THE SUCCESS OF Acquisitions
22.1 Pre-offer issues
22.2 Post-audit and monitoring of post-acquisition success
23 Strategic Acquisitions Involving Common Stock
24 Sensible Motives for Mergers
24.1 Economies of Scale
24.2 Economies of Vertical Integration
24.3 Surplus Funds
24.4 Eliminating Inefficiencies
24.5 To Diversify
25 Right and Wrong Ways to Estimate the Benefits of Mergers
26 Divestitures
26.1 Divestiture Illustrations
27 Conglomerate Mergers and Value Additivity
28 Appendix(es)
29 References
Executive Summary
THE JOURNAL Mergers and Acquisitions listed over gets t 5,000 mergers involving
U.S. corporations in 2000, and the total value of the companies acquired was $1.7
trillion. The year included the announcement of U.S’s largest merger, as AOL and
Time Warner its bus agreed to form a company valued at $350 billion, group
What are the likely gains from mergers? How can managers calculate their benefits
and costs? How can target companies defend themselves against unwelcome
bidders? Who gains and who loses in mergers? This book considers these
questions[3]
Rising earnings pressures, accelerating global competition, and increased
consolidation are driving unprecedented levels of corporate collaboration through
mergers, acquisitions, and strategic alliances.
When two businesses combine their activities, the combination may take the form of
an acquisition (also called a takeover) or a merger (also called an amalgamation).
The primary purpose of any combination should be to increase shareholder wealth,
such an increase normally coming from the effects of synergy.
It must be recognised that in practice the synergistic gains anticipated from a

combination are often disappointing. This may be because managers generally prefer
to grow their businesses through acquisition rather than organically. Although the
Netscape/AOL, Exxon/Mobil, Daimler/Chrysler, and other headline making
“marriages” tend to focus attention on the value of mergers, in many situations
alliances are preferable alternatives for companies looking to achieve strategic
synergies. The numbers speak for themselves. Over the past years, for example,
IBM has formed approximately 800 alliances, AT&T 400, and Hewlett Packard 300.
Such strategic alliances–whether with competitors, suppliers, vendors, or

complementary partners–are frequently the most efficient and effective means for
achieving immediate access to the capital, talent, distribution channels, or
manufacturing capabi1ities essential for maintaining market leadership. Other
considerations–including sobering M&A failure rates–also lead many companies to
prefer alliances. ..though a major reason for seeking merger-related synergies is
improved financial performance, a recent study by Mercer Management Consulting
showed that only about half of the companies formed through mergers exhibited
superior performance with in their industries.
Successful collaboration through strategic alliances hinges on spending advance time

comparing the potential value of the alliance against that of a full-fledged merger or
acquisition. Anticipating and avoiding inherent risks, carefully managing day-to-day
alliance operations, and dissolving ongoing partnerships as soon as their costs out
weigh their value are key success factors.
In this book I will discuss further the meaning of synergy and explain the various
explanations for synergistic gains , Explain why many business combinations do not
in fact realize the gains that were hoped from them. I will also discuss the blend of
assets comprising the consideration on an acquisition. and identify relevant rules
from the City Code which impact on any given situation
1 Mergers versus Alliances
In many situations, mergers and acquisitions are the only options for
maintaining competitiveness. Shareholder demand, for instance, often
mandates spinning off non-core divisions, and then quickly acquiring new
and strategically complementary resources to maximize achievement of core
objectives.
In addition, rapid consolidation in vertical industries such as high technology,

financial services, and telecommunications means companies must initiate
mergers “among equals” or buyouts of smaller firms simply to survive.
Deregulation of industries such as utilities is also driving strategic
consolidation through acquisitions–ensuring the increased size, diversity of
resources, and broader industry “playing field” that facilitate international
leadership. The rapid internationalization of business has also been a strong
influence on merger activity. Many experts, for example, believe that the
euro’s emergence is spurring increased interest in mergers among European
corporations seeking more favorable global positioning.
Often, however, the window of opportunity is so narrow that it is impossible

to negotiate a merger or acquisition in a timely manner. In this case, a
strategic alliance, which can be quickly formed and disbanded if necessary, is
particularly well suited. Especially in the high-technology arena, the ability to
capitalize on strategic alliances enables companies to rapidly penetrate “hot”
new marketplaces through a quick infusion of talent, manufacturing
capabilities, or additional distribution channels, Faced with increased
earnings pressure, corporations also view strategic alliances as a means for
leveraging non-core resources rather than spinning them off. Finally,
strategic alliances allow companies to enter into “trial marriages” before
making the substantial commitment of resources that mergers and
acquisitions entail.
The forms such alliances take are virtually unlimited, but they include joint
marketing arrangements, shared research and development, collaboration on
product design, technology licensing, and outsourcing of virtually all types.
1.1 Alliances with growing

Large corporations that are initiating strategic alliances are more and more
often gravitating toward synergistic arrangements with small or midsize
partners. These arrangements offer:
• Access to top-tier engineering talent that would normally shy away from a
mammoth corporate structure
Instant access to the technology that holds the most potential for shaping
market place demands frequently most available from smaller companies
that maximize incentives for creativity and fast-paced development
A mutually beneficial means for sharing the risk, expense, and potential
return involved with entering a promising new market. For growing
companies, alliances with large corporations provide validation and
accelerated visibility for their products, increased overall valuation of their
companies, and added clout that makes funding more readily available.
A recent alliance between a world-class computer manufacturer and a

smaller developer of desktop management solutions for enterprises
illustrates the lure of such arrangements. The alliance agreement calls for the
manufacturer to pre-load the developer’s leading-edge applications, which
are rapidly becoming “must have” integration tools, onto its enterprise PCs.
The manufacturer’s new ability to offer this unique and in-demand enterprise
solution is jump-starting its potential for new growth. In turn, its smaller
developer partner now enjoys an exponential increase in prospects. Both
companies risked some up-front investment to optimize the performance of
the software on the manufacturer’s systems, but the promise of a substantial
return makes the strategic arrangement compelling[1]
1.2 Leveraging Rewards while lowering risks

Risk, is a paramount consideration with even the most straightforward
alliances. There is always the concern that one alliance partner will decide to
leverage resources gained from the temporary arrangement and move
forward independently or with different partners. The risk is as important to
large companies as it is to smaller firms because of their increasing
dependence on intellectual property and cross-border partnerships for
renewed competitiveness.
Because today’s economy is founded on knowledge transfer, alliance-related

risks have become especially complex. The potential for “stealing” such
intangible re as marketing know-how and engineering talent is daunting to
companies of all sizes, and the consequences are far-reaching. The risk
grows when alliances are international, especially when distance and differing
ways of conducting business complicate daily oversight of alliance activities.
Risk also increases in relation to the level of commitment an alliance

requires. The more two companies share in order to form a rewarding
venture, the more resources they stand to permanently sacrifice should the
venture fail. And failure is a common occurrence. In fact, more than half of
all alliances between large and small technology s fail after four years.
1.3 Rules of the road.
The potential for such risk requires following “rules of the road” when
structuring each
partnership. There are both legal and strategic routes for getting the most
out of every
alliance while minimizing their hazards. Among steps companies should take
to tap into the “gold mines” that alliances offer are the following:
• Begin with due diligence. Due diligence is important both for assessing
the potential contribution of new partners, and for evaluating companies that
have worked with yours in the past, but through markedly different
arrangements. For instance, corporations entering into alliances with former
vendors should use due diligence to assure that the vendors have the
financial and management depth to execute new roles. Companies engaging
in international alliances should find an overseas firm with skill in ferreting
out and interpreting documentation about potential foreign partners. In many
countries, financial documentation is difficult to access except via a local,
hands-on approach.
• Be specific. Move forward with alliance arrangements only after defining

and documenting clear objectives, performance benchmarks, and specific
timetables for key milestones.
• Assure shared values. Even if their companies are markedly different,

alliance partners must share basic values if their initiatives are to succeed.
For example, a large public company that wants to accelerate research and
development may find a good partner in a growing and innovative
engineering firm–but only if that firm also values the strict financial controls
that are important to the larger company.
• Work toward dedicated arrangements. Avoid staffing alliances with

managers and employees who serve two masters with substantial and often
conflicting demands. For example, if one partner’s incentives relate entirely
to sales, but the other’s relate to new product development, those working
on the alliance, and thus influenced by both incentive plans, will lack clear
direction. You must create consistent incentives for success that tap into the
staff’s inherent motivations. And you should also put your most goal-oriented
in-house staff in charge of managing the alliance.
• Move toward permanent knowledge transfer. Whenever possible,

rotate large numbers of in-house employees through an alliance as a training
tool. Without violating terms that delineate ownership of intellectual
property, take advantage of cross-training opportunities.
• Capitalize on opportunities for changing your existing corporate
culture. Large companies often ally with small and midsize firms to gain
access to teams that are more entrepreneurial than their own, particularly
when new-market entry is the goal. If they properly structure these alliances,
they can gain a major permanent benefit from a temporary partnership–a
ramp-up of their full-time employees’ entrepreneurial drive By organizing
entrepreneurial incentives for the individuals charged with managing these
alliances–such as offering managers a reward of in creased stock options
based on meeting alliance-specific goals–companies can pull these managers
out of established political infrastructures that may inhibit risk taking, and
modify the way they tend to approach their work in general. Managers’
teams may also adopt this new approach by osmosis–potentially leading to
new levels of innovation that translate into additional market opportunities.
Allow for continual change. The best alliances are structured with room
for experimentation, pullbacks due to adverse marketplace changes, and
dissolution if they are hampering financial performance.
Document with care. Even relatively low-risk ventures such as joint

product marketing require documentation. In this case, a news release can
serve as a document for cementing the commitment of each side to honor
related parameters. High-risk alliances, such as those related to joint
development of core products, involve important commitments of
technology, equity, and personnel, and call for extremely comprehensive
written contracts that protect all involved parties. The documentation, for
instance, should cover capital requirements and ownership parameters,
employee incentive issues, third-party disclosures, access to future
technology developments, buyback of rights, dispute resolution mechanisms,
and a range of;:other considerations.
• Possible conclusion. Documentation is also important when companies

approach strategic alliances from a slightly different vantage point–if, say,
the alliance is acknowledged (by at least one party) as a stepping tone to a
do-it-alone strategy. For instance, a manufacturer may deliberately form a
temporary alliance with a distributor with the intent to convert to direct sales
when resources allow. In other situations, companies may question their
partner’s commitment and need to be able to regain 100% control if they are
proven right. These companies should enter alliances with extreme care not
to share assets that could ever be leveraged for the other party’s growth,
and to have documentation in place that provides for mutually advantageous
exit strategies.
• Reconsider acquisitions. Typically, alliance-related contracts anticipate

that one company may seek to acquire the other should the arrangement
show promise. Taking a long-term view of the alliance encourages a highly
collaborative and trusting relationship early on–a precursor to a successful
corporate marriage.
The return on successful strategic alliances can be significant, which justifies
the substantial investment of resources in their advance planning. When
structured with care, these alliances become essential to the growth of
corporations across industries, including those that have already achieved
synergies through previous M&A activity.[1]
2 ARGUMENTS FOR AND AGAINST

MERGERS AND ACQUISITIONS
2.1 Methods of amalgamations and takeovers
Though the terms are used loosely to describe a variety of activities, in every
case the end result is that two companies become a single enterprise, in fact
if not in name.
Whether by amalgamation or by takeover, the end result may be achieved

by:
(a) transfer of assets; or
(b) transfer of shares
The two methods are summarised below.
TRANSFER OF ASSETS TRANSFER OF

SHARES
TAKEOVER B acquires trade and assets B acquires shares in A
from A for cash. A is then from A’s shareholders in
(B TAKES OVER A) liquidated, and the exchange for cash. A, as a
proceeds received by the subsidiary of B, may
old shareholders of A subsequently transfer its
trade and assets to its
new parent company B
MERGER Z acquires trade and assets Z acquires shares in X and
from both X and Y in return Y in return for its own
(X and Y merge to for shares in Z. X and Y are shares. X and Y as
form Z) then liquidated and the subsidiaries of Z may
shares in Z distributed in subsequently transfer their
specie to the shareholders trade and assets to their
of X and Y. new parent company (Z).
Other names that are used are Acquisition (Takeover) or Merger
(Amalgamation).
2.2 Rationale for growth by acquisition

The ultimate justification of any policy is that it leads to an increase in value,
ie, it increases shareholder wealth. As in capital budgeting where projects
should be accepted if they have a positive NPV, in a similar way mergers
should be pursued if they increase the wealth of shareholders
Suppose firm A (the acquirer) has a market value of £2m and it buys firm B,
market value £2m, at its. current market price.
If the resultant new firm AB has a market value in excess of £4m then
the merger can be counted as a success, if less it will be a failure.
Essentially, for a successful merger we should be looking for a situation
where:
Market value of the combined companies (AB) > Market value of A +

Market value of B
If this situation occurs we have experienced synergy, that is, the whole is
worth more than the sum of the parts. This is often expressed as:
2+2=5
It is important to note that synergy is not automatic. In an efficient stock

market A and B will be correctly valued before the acquisition and we need
to ask how synergy will be achieved, i.e., why any increase in value should
occur.
2.3 Sources of synergy

Some sources of synergy are:
(a) operating economies;
(b) Market power;
(c) Financial gains; and
(d) Others.
We will examine each in turn.

2.3.1 synergy from operating economies
(a) Economies of scale
Horizontal mergers (acquisition of a company in a similar line of business)

are often claimed to reduce costs and therefore increase profits due to
economies of scale. These can occur in the production, marketing or finance
areas. Note that these gains are not automatic and diseconomies of scale
may also be experienced. These benefits are sometimes also claimed for
conglomerate mergers (acquisition of companies in unrelated areas of
business) in financial and marketing costs.
(b) Economies of vertical integration
Some acquisitions involve buying out other companies in the same

production chain, eg, a manufacturer buying out a raw material supplier or a
retailer. This can increase profits by ‘cutting out the middle man’.
(c) Complementary resources
It is sometimes argued that by combining the strengths of two companies a

synergistic result can be obtained. For example, combining a company
specializing in research and development with a company strong in the
marketing area could lead to gains.
(d) Elimination of inefficiency
If the victim company is badly managed its performance and hence its value
can be improved by the elimination of inefficiencies. Improvements could be
obtained in the areas of production, marketing and finance.
2.4 Financial synergy

Several financial arguments are proposed in this area.
(a) Diversification
The argument goes that diversification normally reduces risk. If the earnings
of the merged companies simply stay the same (ie, no operating economies
are obtained) there could still be an increase in value of the company due to
the lower risk. This argument is developed by application #2.
The following data are available for two companies

Company A Company B
(i) Market value £2m £2m
(ii) Earnings to perpetuity £0.2m £0.4m
(iii) Rate of return 10% 20%
(iv) Standard deviation of return 8% 18%
Correlation coefficient between returns of A and B = 0.3
The risk and return of the combined company may be calculated in a similar
way to the analysis of a two asset portfolio (in portfolio theory).
Return (assuming no operating economies) = £0.2 + £0.4m= £0.6m
The same total earnings are available but the risk is considerably less than
the weighted average of the risk of the two individual companies (18+8)/2 =
13%
Therefore the value of the combined company should be in excess of £4m

and synergistic gains will have been obtained.
The major fallacy in this argument is that it is based on total risk. Well-
diversified shareholders evaluate companies on the basis of systematic risk,
which, in one of the conclusions of CAPM, cannot be eliminated by
diversification.
Assume, for example, that the following additional data were available:
βA = 1
βB =3.00
Rm = 10%
Rf = 5%
The systematic risk of the combined company would simply be given by the
weighted average of the two β factors:
(0.5 x 1.00) + (0.5 x 3.00) = 2.00
This gives an implied required rate of return of:
Rf+ β(Rm–Rf) = 5%+200(10%–5%)
= 15%
On total earnings to perpetuity of £0.6m this would give a combined

company value of:
£0.6m/0.15 =£4m
No increase in value has occurred because no risk reduction has been

obtained. The systematic risk of the combined company is simply the
weighted average of the individual systematic risks.
From a shareholder’s point of view, in the absence of any operating

economies, there appears to be no gain from the merger.
Note, however, that managers often concentrate on total risk, as total risk
affects their job security and the diversification argument can make sense
from a managerial viewpoint if not a shareholder’s.
(b) Diversification and financing
If the future cash flow streams of the two companies are not perfectly
positively correlated then by combining the two companies the variability of
their operating cash flow may be reduced. A more stable cash flow is more
attractive to creditors and this could lead to cheaper financing.
(c) The ‘boot strap’ or PE game
It is often argued that companies with high PE ratios are in a good position to
acquire other companies as they can impose their high PE ratio on the victim
firm and increase its value.(see application #3)
2.4.2 Application #3
The following data are available:
Company A Company B
(i) Earnings available to shareholders £0.2m £0.4m
(ii) PE ratio 10 5
(iii) Market capitalisation (i) x (ii) £2m £2m
(iv) Number of shares Im Im
(v) Value per share £2 £2
Assume company A decided to buy company B at market value on a share

for share basis.
This would involve the issue of 1m new shares by company A. The resultant
company
(assuming no synergistic effects) would look something like this:
Company AB
Earnings available to ordinary shareholders £0.6m
Number of shares 2m
Earnings per share £0.3
The value per share will depend upon the PE ratio set by the market. Both
parties would hope that the market would continue to apply A’s PE ratio to
the combined company. This would lead to a share price of: EPS x PE ratio =
30px 10= £3 and a market capitalization of:
£3 per share x 2m shares = £6m
This is an overall increase in value of (over the value of the two companies
prior to the merger) and would benefit both sets of shareholders.
The question we need to ask is ‘ In an efficient market why should this

occur?’
The low PE ratio given to B presumably reflected its high risk or poor growth
prospects. Why should the market change its mind simply because ownership
has changed?
It might do so because of likely future operating economies, but not simply

because A has a high PE ratio. The moral is clear – a high PE ratio in the
acquiring company in itself is not the cause of any increase in value. In an
efficient market increases in value will be caused by other benefits. If no
other benefits are forthcoming the new PE ratio will simply be the weighted
average of the individual PE ratios, i.e.:
[(Earnings of Ax PE ratio of A) + (Earnings of B x PE ratio of B)]/( Earnings of

A + B)
= [(0.2m x 10) + (0.4m x 5]/(0.2m + 0.4m)
=6.667
The combined market capitalization of A and B would then be:
30p x 2m shares x6.667 = £4m - i.e., no gain to shareholders.
(d) Other financial benefits
These largely revolve around the elimination of inefficient financial

management practices. Examples include:
(i) Buying low geared companies with good asset backing in order that they
may be geared up to obtain the benefit of the corporation tax shield on debt.
(ii) Buying companies with accumulated tax losses in order that they may be
offset against profits of the acquiring company.
3 Other synergistic effects

(a) Surplus managerial talent
Companies with highly skilled managers can make use of this resource only if
they have problems to solve. The acquisition of inefficient companies is
sometimes the only way of fully utilizing skilled managers.
(b) Surplus cash
Companies with large amounts of surplus cash may see the acquisition of
other companies as the only possible application for these funds. Of course,
increased dividends could cure the problem of surplus cash, but this may be
rejected for reasons of tax or dividend stability.
(c) Market power
Horizontal mergers may enable the firm to obtain a degree of monopoly

power which could increase its profitability.
(d) Speed
Acquisition may be far faster than organic growth in obtaining a presence in

a new and growing market.
4 Why a company may want to be
acquired
Many acquisitions are by mutual agreement, so small companies being
acquired may welcome such a move. There are a number of possible
reasons:
‘ (a) Personal – e.g., to retire, for security, because of the problem of

inheritance tax.
(b) Business – an expanding small company may find that it reaches a size
where it is impossible to restrain growth, but funds or management expertise
are lacking.
(c) Technical – increasing sophistication presents a problem for the small

company, e.g.:
(i) cost of research and development may be prohibitive;
(ii) inability to employ specialized expertise;
(iii) inability to offer a complete range of services or products to customers.
Such factors can apply to companies that are quite large by most standards,
eg, Rolls-Royce Ltd was too small to absorb the losses on one new engine.
5 Gains from mergers

Acquisition is a popular route to growth and we have noted several
arguments to justify expansion based on acquisition. We have also seen that
many of these arguments are suspect.
Research in this area has two major conclusions:
(a) Value or synergistic gains are in practice quite small.
(b) Bidding companies usually pay a substantial premium over the market
value of the victim company prior to the bid.
The implications of these findings are quite significant and may be

demonstrated by returning to Application #3 of our two companies, A and
B, both having a market value of £2m each in isolation.
Let us assume that when these are combined a small amount of synergy is
obtained and their combined value rises to £4.5m.
Let us further assume that to acquire B’s shares A has had to pay a
premium of £1m, i.e., total cost of B is £3.m
The benefit/(cost) of the takeover to A’s shareholders is as follows:
£
Market value of AB 4.5m
Original value of A 2.0m
Price paid for B 3.0m
Loss (0.5m)
This loss will be to the cost of the acquiring company shareholders but to the
benefit of the victim company shareholders (as they received the £1 m
premium).
This in fact reflects the overall conclusion of research in this area: the
consistent winners In mergers and takeovers are victim company
shareholders; the consistent losers are acquiring company shareholders.
6 Causes of failure
Reasons advanced for the high failure rate of takeovers are:
(a) Over-optimistic assessment of economies of scale. Such economies can

be achieved at relatively small size; expansion beyond the optimum results
in disproportionate cost disadvantages.
(b) Inadequate preliminary investigation combined with an inability to

implement th amalgamation efficiently.
(c) Insufficient appreciation of the personnel problems which will arise.
(d) Dominance of subjective factors such as the status of the respective

boards of directors.
Perhaps the fact that acquisition is often favored as an alternative to

expansion by other means implies a tendency towards laziness in
management. It is probably considered easier to acquire an existing business
rather than to subject oneself to the discipline of seeking and justifying more
difficult investment projects. Furthermore, the high level of redundancies
evidenced in larger groups indicates that mergers and acquisitions create a
situation where rationalization (which would otherwise be shirked) may be
carried out more acceptably.
7 Conclusions on growth by
acquisition
(a) Not all mergers are failures; some in fact are very successful. On
average, however, research shows that expansion based on merger and
takeover seems to bring few value gains to acquiring company shareholders.
(b) Mergers, however, are often in the interests of managers. They view
success in a different light from shareholders and are often more concerned
with the job security and career prospects brought by sheer size.
(c) There are alternatives to growth by acquisition. It is sometimes argued

that as markets become more global mergers are required to allow
companies to be large enough to compete. For example, telecommunications
companies need to be very large to support the required research and
development overhead. Other industries have, however, found ways round
this problem. Joint ventures in the car industry between Honda/BL and
Ford/Mazda are examples of alternatives to merger.
8 Merger and acquisition activity

in different countries
Merger and acquisition activity is much more common in the UK and USA
than in Germany or Japan. This is principally because banks dominate the
financial systems of Germany and Japan, and develop long-term relationships
with the companies they serve, taking significant equity stakes and perhaps
having board representation. These banks would not sell their stakes to a
predator, whatever price is offered.
In the UK and USA most shares are held by institutional investors (pension
funds, unit trusts, insurance companies, etc,). Their traditional tendency has
been to sell their shares if they are dissatisfied with the company’s
performance or if offered a significant premium to market price.
Some commentators have also argued that lax accounting standards in the
UK have encouraged takeover activity in the past. Mergers were generously
defined in SSAP 23 so that many acquisitions could be structured to fall
within the SSAP 23 definition of a merger and so be accounted for using
merger accounting. Additionally SSAP 22 allows purchased goodwill to be
eliminated directly against reserves on acquisition, which is more generous
than the international standard requiring capitalization and amortization. The
ASB are grappling with these problems as part of their current work
programmed and hope that FRS 6 will prove more acceptable than SSAP
The implications of high takeover activity in the UK and USA are not clear
cut. One view is that this contributes to the efficiency of the market, with
resources being directed towards good managements. The opposing view is
that most anticipated synergy gains are not realized in practice and that high
takeover activity simply leads to short-term investment horizons by
managers. This is an interesting area of the current debate on corporate
governance in the UK.
9 STRATEGIES AND TACTICS OF

MERGERS AND ACQUISITIONS
Both organic growth and external growth as possible long-term growth
strategies. No external growth should be considered unless the organic
alternative has been dismissed as inferior. Assuming then that external
growth has been decided upon, the remainder of this chapter considers the
steps to be taken. A possible sequence of steps is as follows.
9.1 Strategic steps

Step 1 -Appraise possible acquisitions
Step 2 - Select the best acquisition target
Step 3 Decide on the financial strategy ie, the amount and the structure of
the consideration
9.2 Tactical steps

Step 1 - Launch a dawn raid subject to the City Code
Step 2 -Make a public offer for the shares not held
Step 3 - Success will be achieved if more than 50% of the target company’s
shares are acquired
10 IDENTIFYING POSSIBLE
ACQUISITION TARGETS
10.1 Information required for appraisal of
acquisitions
Once a company has decided to expand by acquisition, it must seek out
prospective targets in the business sectors it is interested in.
For each company examined, clearly the first objective is to examine the
prospect closely from both a commercial and financial viewpoint. In general
businesses are acquired as going concerns rather than the purchase of
specific assets, and thus this section summarizes the variety of areas which
require special examination:
(a) Organization
Special requirements:
(i) Organization chart.
(ii) Key management and quality.
(iii) Employee analysis.
(iv) Terms and conditions.
(v) Unionization and industrial relations.
(vi) Pension arrangements.
Clearly, businesses are about people, and their quality and organization
requires examination. Further, comparison needs to be made with existing
group remuneration levels and pensions, to determine the financial impact of
their adoption, where appropriate, on the acquisition.
(b) Sales and marketing
(i) Historic and future sales volumes by:
(1) Major product group.

(2) Geographical location.
(3) Major channels of distribution.
(ii) Market position, including customers and competition for major product
groups.
(iii) Sales organization.
(iv) Normal trading terms.
(v) Historic sales and promotions expenditure by product group.
(vi) Trade marks and patents byproduct group.
This additional information should provide a detailed assessment of the

market and customer base to be acquired.
(c) Production, supply and distribution
(i) Total capacity and current usage levels.
(ii) Need for future capital investment to replace existing assets, or meet
expanded volume requirements.
This would provide an assessment of the overhead burden due to

undercapacity production and of the potential future capital requirements to
maintain the required productive capacity of the business.
(d) Technology
(I) Details of particular technical skills inherent in the acquisition.
(ii) Research and development organization and historic expenditure.
Thus, an analysis would be made of the technical assets acquired, and their
past and potential future maintenance costs.
(e) Accounting information
(i) All companies in business acquired, and legal structure.

(ii) Company searches for all companies.
(iii) Historic consolidated and individual company accounts.
(iv) Detailed explanation of accounting policies.
(v) Explanation for any extraordinaries, exceptional or other non-recurring

income or expenditure.
(vi) Explanation of major fluctuations in sales, gross margins, overheads and

capital employed.
These provide the background for basic financial analysis.
(f) Treasury information
(i) Amounts and terms of bank facilities and all other external loans and
leasing facilities (including capitalised value, if not capitalised).
(ii) Details of security for such facilities.
(iii) Details of restrictive covenants and trust deeds for such facilities.
(iv) Details of guarantees and indemnities given for financial bonds, letters of
credit, etc.
(v) Details of forward foreign exchange contracts, and exchange

management policies.
All this information will be useful in planning the financial absorption of the
business into the acquiring group, and will in particular reveal any ‘hidden
assets’ (eg, low coupon loans) and ‘hidden liabilities’ (guarantees liable to be
called, or hedged foreign exchange positions).
(g) Tax information
(i) Historic tax computations, agreed, submitted and unsubmitted by

company.
(ii) Significant disputes with Revenue.
(iii) Trading losses brought forward.

(iv) Potential deferred tax not recorded as a liability in the accounts.
(v) Other potential tax liabilities, including VAT and PAYE.
(vi) Understanding of tax position of vendors, especially with respect to

capital gains tax liability as a result of sale.
This can identify any potential tax assets (eg, utilisable losses) and liabilities
(eg, likely payments of tax not provided), and assist in pricing and
structuring the transaction having regard to the vendor’s tax position.
(h) Other commercial/financial information
(i) Details of ordinary and preference shareholders, with amounts held by

each class, and voting restrictions if appropriate, together with share options
held and partly paid shares.
(ii) Details of trading with related parties; management charges and prices.
(iii) Contingent liabilities, including litigation, forward purchase or sales

contracts, including capital commitments and loss-making contracts not
otherwise provided for.
(iv) Actuarial assessment of current pension funding, with assumptions.
(v) Details of important trading agreements.
This relates primarily to a better understanding of the capital structure and

shareholdings to be acquired, and any potential financial liabilities
overhanging the acquired company, of which the most significant may well
be underfunded pension schemes.
11 ACQUISITION CONSIDERATION
AND STRUCTURE
In general a purchaser and a vendor will need to agree on three basic issues
in regard to an acquisition:
(a) Whether shares or assets are to be purchased.
(b) Financial value.
(c) Type of consideration.

11.1 Share or asset purchase
The ‘shares or asset’ issue does not generally arise when public companies
are acquired, but with the purchase of private companies it will usually turn
on the following points:
(a) An asset purchase will enable the purchaser to claim tax allowances on
certain assets acquired, principally fixed assets other than land. The vendor,
on the other hand, will probably have certain tax ‘claw-backs’ or ‘balancing
charges’ to pay arising from tax allowances he has taken earlier, again
principally on fixed assets other than land. The consequence is that, at least
so far as tax efficiency is concerned, vendors do not generally favour this
route, whilst acquirers seek it wherever possible.
(b) A share purchase is much more complicated, principally because of all the
actual and contingent liabilities attaching to a company, as opposed to the
underlying assets in the business, which can be sold separately from such
liabilities. The documentation is much more lengthy and the cost of
professional advisors far greater. In addition, stamp duty may be payable on
the entire share transfer (as opposed to only on the property element of an
asset sale). Where the vendor can be persuaded that his tax position is not
prejudiced, therefore, this argues for an asset purchase.
A technique commonly used to mitigate the disadvantages of a share

purchase is the hivedown. This is generally applied to a company only part
of whose business is wanted by the purchaser. The part required is
transferred to a clean ‘off the shelf or new company owned by the vendor;
such a transfer can be accomplished without adverse tax consequences. The
clean company, containing the business, is then sold without the
documentary negotiation and complications which normally accompany the
sale of a company which has been in existence for some time.
11.2 Financial value

The financial value of the business is clearly a matter for bargaining between
the vendor and the acquirer. In so doing the following points should be taken
into account:
(a) If the acquisition is for shares, any borrowings within the company
would need to be added to the cost of the shares in computing the final
consideration for the company. The combined consideration would then
represent the financial value of the underlying assets concerned, and would
normally be the price on which the investment appraisal for the acquisition
would be based. Thus, total consideration for a company whose shares are
valued at 200, and whose internal borrowings are 100, is in reality 300.
(b) Tax liabilities or advantages to the vendor or acquirer. The
structure of the acquisition clearly affects the tax position of both parties,
and there may be other tax assets or liabilities (eg, tax losses carried
forward) which are additions to the commercial value of the business. These
would affect the overall value of the business.
(c) Debt consideration bearing below market interest. Either by way of

consideration (see
below) for shares, or existing internal borrowings acquired with the business.
The present value of the difference over the life of the borrowings between
the going market inter rate and the actual rate on the bon concerned is
generally deducted from the total consideration.
Thus, where the total consideration is nominally 500, of which 300 is a loan,
the inter rate on which is 7% (when the market rate is 10%) and the after-
tax present value of t difference between the two interest rates is 10, the
total consideration could be taken to 490.
(d) Conventional methods of valuing shares include earnings-based models,

dividend valuation models and asset-based models. 4.4 Type of consideration
The means of transferring the financial value of the shares or assets of the
business, ti consideration, can be satisfied in a combination of several
alternatives:
(a) Cash.
(b) Debt.
(c) Preference shares.
(d) Ordinary shares.
In addition, debt and preference share consideration can be convertible into

ordinary shares.
The value of ordinary shares issued is, generally speaking, based on their
market value at the tin of issue. In principle, too, the issue of shares is no
more expensive to the purchaser than cash debt consideration, despite the
implicit difference in the cost of equity and debt. The reason for ti is that, in
general, projects, whether internal or external (ie, acquisitions) should be
considered to financed from a ‘pool’ of financial resources based on the
optimum relationship between debt a equity, and basing the appropriate
hurdle on the ‘blended’ cost of such a pool. If equity is issued consideration
for a project, the change in the debt/equity ratio resulting is usually
considered to temporary, and the group will subsequently make appropriate
adjustments in the level of debt order to optimise the ratio. Adjustments
would equally have to be made where debt rather ti equity is issued.
There are, however, certain complicating factors which require to be borne in

mind and may against the use of such shares:
(a) Temporary depression of share price
The acquirer may feel the then current share price might rise in the future,
either bec the share market as a whole is depressed, or because the value of
the acquiring comp shares are temporarily depressed. Thus, the vendor may
be getting the shares ‘cheap’.
(b) Dilution of existing shareholders’ interests
This will be a problem where the acquirer has a limited number of major
shareholders may not, for control or other reasons, wish to see their
interests diluted.
(c) Difficulty in valuing shares
Unquoted companies may have difficulty in establishing an appropriate price.
(d) Maintenance of debt/equity ratio
If the change in the equity base is large in relation to the pre-acquisition

level of equity, it may be difficult to get back to an optimum debt/equity
ratio. Under these circumstances, the ordinary shares issue may indeed have
a higher cost, closer to the cost of equity rather than to the ‘blended cost of
capital’.
The type, cost and term/redemption arrangement of debt or preference

shares to be issued is a matter for negotiation. However, the vendor’s capital
gains tax may be deferred by the issue of either debt or shares of any type,
the deferral being until repayment date/redemption date/date of sale of
ordinary shares.
Where debt or preference shares are concerned, there is often a quid pro quo
exacted by the acquirer in the form of a lower interest and dividend rate than
the going market, in return for the tax advantage conveyed.
12 ACQUISITION OF QUOTED
COMPANIES
12.1 The regulation of takeovers
The acquisition of quoted companies is circumscribed by the City Code on
Takeovers and Mergers (‘the City Code’), which is the responsibility of the
Panel on Takeovers and Mergers. This code does not have the force of law,
but it is enforced by the various City regulatory authorities, including the
Stock Exchange, and specifically by the Panel on Takeovers and Mergers (the
‘Takeover Panel’). Its basic principle is that of equity between one
shareholder and another, and it sets out rules for the conduct of such
acquisitions.
The Stock Exchange Yellow Book also has certain points to make in these
circumstances:
(a) Details of documents to be issued during bids for quoted companies.
(b) Such documents to be cleared by the Stock Exchange.
(c) Timely announcement of all price sensitive information.
The Office of Fair Trading (OFT) regulates the monopoly aspects of bids.
Many bids, because of their size, will require review by the OFT, and a limited
number will subsequently be referred to the Monopolies Commission. In
addition, if the offer gives rises to a concentration (ie, a potential monopoly)
within the EC, the European Commission may initiate proceedings. This can
result in considerable delay, and constitutes grounds for abandoning a bid.
12.2 Procedure for a public bid – preliminary

steps
In considering a public bid, a group will generally have the following
advisors:
(a) Merchant bank – acting as general financial advisors.
(b) Legal advisors – to ensure compliance with the law, particularly in

preparation of documents.
(c) Accountants – to provide any necessary support for financial information

in documents.
(d) Stockbrokers – to assist with Stock Exchange requirements and
underwriting, where appropriate.
Such a group would generally examine the publicly available information on

the target company, and then would make a decision with its merchant
bankers as to whether or not to approach the target’s board/management in
advance of a bid. It would be normal to do this in the following
circumstances:
(a) Where the target has a significant board/management shareholding.
(b) Where there appears to be a good chance of making an offer for the
target ‘agreed’ management before the bid is announced.
(c) Where the bidding group does not wish to appear ‘hostile’ or ‘predatorial’.
The purpose of these preliminary discussions would be to discuss the purpose

of the would- bidder, and to ascertain whether a price acceptable to both
parties can be struck. A further bon might be the acceptance of a significant
block of shareholders for such a bid.
If an acquirer does not approach management in advance, the subsequent

bid will almost certair be taken to be ‘hostile’ or ‘predatorial’ and will result in
a spirited defence by that managemei However, such an approach does have
the disadvantage that it alerts the management to the possi bid, and gives
them more time to prepare a suitable defence.
13 City Code regulation of

acquisitions
In either event, the would-be acquirer may decide, with the help of his
advisors, to combine his b with the acquisition of shares in the market. Such
action is governed by detailed rules set out in ti City Code and in the
Companies Act 1985. The basic points are:
(a) 3% disclosure
A would-be bidder, together with related parties, can build up a stake of 3%

without at obligations to disclose this to the target company. Over 3% the
stake must be disclosed the target company under the statutory rules for
disclosure of substantial interests, th? giving warning to the management of
a possible bid.
(b) Limits on purchases when shareholding is between 15% and

30%
A shareholder cannot within any seven day period acquire a further block of
shares of mo
than 10% if, after this additional purchase, his aggregate holding will be in
the range of 15% to 30%.
This is designed to limit the speed at which a bidder can acquire a significant
stake, so ti the target’s management have a fair chance to comment and
prepare for a possible bid. T exceptions to this rule are acquisitions:
(i) from a single shareholder, or
(ii) pursuant to a tender offer, or
(iii) immediately preceding, and conditional upon, an announcement of an

offer which is to be recommended by the board of the target company.
There are also provisions for disclosing the acquisition of such an interest to
the target company much more quickly than required under the Companies
Act.
The significance of this rule is that it limits to 15% of the total available the
number shares that can be bought in a ‘dawn raid’ – a quick, organized
share-buying operation usually over in a few minutes, which is often a
prelude to a full bid. Such raids considered by many to be inequitable to non-
institutional shareholders who will not hear the operation until it is over; but
in any event, they are much rarer than in the past, since institutional
shareholders have found in general that they obtain more for their shares by
waiting for a full bid.
It is worth noting that it will, in general, take a minimum of fifteen days to

build up a 30% stake as a result of this rule.
(c) Compulsory offer if shareholding exceeds 30%
If a shareholding exceeds 30% a bidder must make an offer conditional on a

minimum acceptance of 50%, no Monopolies and Mergers Commission
reference and no European Commission reference.
(d) Offer period
The offer period starts when an announcement is made of a proposed or

possible offer.
This date is significant in determining the value of the offer to shareholders.

If the offeror has purchased shares in the offered company within three
months prior to the commencement of the offer period, the offer to
shareholders must not be on less favorable terms.
(e) ‘Unconditional as to acceptances’
When an offer receives acceptances from shareholders, the offer and

acceptance are conditional upon:
(i) a minimum percentage of share capital being acquired by the

offeror;
(ii) a time period within which the shareholder can withdraw his
acceptance.
The term ‘unconditional as to acceptances’ means that the offeror has

obtained the minimum percentage and declares that accepting shareholders
can no longer withdraw their acceptance.
If a would-be bidder decides to make an offer, the City Code is specific about
the information it must contain. Furthermore, it cannot be withdrawn without
the Takeover Panel’s consent, unless it lapses or certain conditions are not
met. Two conditions are common to most offers:
(a) No reference to the Monopolies and Mergers Commission.
(b) Acceptances in excess of 50% and, at the option of the bidder, 90% of
the shareholding are received.
If acceptances exceed 90%, the offer can in general be enforced compulsorily

for 100% of the shares.
13.1 The stages of an offer

It is difficult to be precise about the course of a bid, and later in the text the
section on Defence gives an example of what might be involved. However,
there are certain deadlines and rules which the Code specifies:
(a) Offer document
This must be posted within twenty-eight days of the announcement of a bid,

and is subject to the provisions of the Yellow Book. It will also generally
contain a profit forecast (with merchant banker’s and accountant’s reports),
and often a property revaluation.
(b) Closing date

An offer must generally stay open for twenty-one days after posting. If
revised, it must stay open for a further fourteen days.
(c) Withdrawal of acceptances
A shareholder may withdraw his acceptance forty-two days after the offer
document has been posted, if the offer has not gone ‘unconditional’.
(d) Revision
No offer may be revised longer than forty-six days after posting.
(e) Lapsing
An offer must go unconditional, or will lapse sixty days after posting. An

extension may, however, be granted if another bidder has made an offer.
Offers may be for cash or, in principle, for any of the alternative forms of
consideration set out above. If for cash, the bidder may use its existing cash
or borrowing facilities, or, where shares are available as an alternative, such
shares may be underwritten, so that acceptors can accept cash if they desire.
14 ACQUISITION OF PRIVATE
COMPANIES
14.1 Preliminary considerations
The acquisition of private companies can be undertaken without public
scrutiny and, therefore, with the following particular characteristics:
(a) Detailed commercial and financial information will be available in advance

of an agreement.
(b) There will be an agreed price structure and consideration to suit both
parties.
(c) There will be detailed legal documentation.
Issues of desirable information, price structure and consideration have been

discussed earlier. There are often one or more intermediaries involved who
have been instrumental in bringing the two parties together. They may be
merchant/investment banks, or they may be specialist acquisition brokers,
usually small operations and often single traders. The scale of remuneration
to the intermediaries is normally a function of the final amount of
consideration paid. The fees will be charged either to the acquiring or to the
acquired company, depending on for whom the intermediary is acting.
An important early stage in a transaction, usually after an initial expression

of interest by a would- be acquirer, is the signing of a confidentiality letter by
the latter. This would normally bind the would-be acquirer legally not to
disclose any confidential information received by it to evaluate the possible
acquisition to third parties, unless such information were already in its
possession or in the public domain. It would also require, in the event of the
transaction not going ahead, any confidential papers in its possession to be
returned.
14.2 Documentation of the agreement

Documentation for private transactions usually consists of a contract between
the two parties with, inter alia, the following elements:
(a) Structure and consideration for the transaction.
(b) Warranties given by the vendor in respect of the business covering, inter
alia, the following:
(i) Accuracy of all information supplied and statements made by the company
to be acquired.
(ii) Value of assets and liabilities of the business at a certain date after the
latest accounts and, often, trading results from the latter date, either before
or after the date of contract.
(iii) No material adverse change since the latest accounts.
(iv) Specifically, collectability of debtors and saleability of stocks.
(v) Details of contingent liabilities, including guarantees, litigation, unfunded

pension rights, and all material contracts and contracts with related parties.
(c) Tax indemnity covering past, current, and often future tax liabilities
resulting from trading up to the date of acquisition.
(d) Limits on vendor’s liability. Both warranties and tax indemnity may give
rise to financial obligations by the vendor. The document would indicate how
these might be satisfied, for instance against part of the consideration
withheld in the first instance.
(e) Disclosure letter. The contract will normally refer to a ‘disclosure letter’,
in which exceptions to the warranties and indemnities given are noted by the
vendor’s solicitors and tabled prior to contract and/or complejion. Thus, if a
specific warranty was that no material litigation exists, the disclosure letter
would note any legal actions currently in course. Conceptually, anything
disclosed• in this letter cannot form the basis of a claim under a warranty or
indemnity, since the purchaser has been made aware of it prior to contract
and completion.
The contract is normally signed, with a nominated completion date, and may
be conditional on one or both parties fulfilling certain conditions. These might
be:
(a) No reference to the Monopolies and Mergers Commission.
(b) A satisfactory financial investigation.
(c) A satisfactory tax investigation.
In fact, both financial and tax investigations may take place before contract;
between contract and completion; and even after completion. In the two
latter cases they may be used as a basis for warranty/indemnity claims.
Completion is then accomplished when consideration passes in exchange for

shares. However, an
important event at either or both contract or completion is the tabling of a

disclosure letter, as desc above. This provides the vendor with a last chance
to declare any facts which might form the basis for subsequent claims, and
the purchaser to repudiate the contract.
15 DEFENCE AGAINST TAKEOVERS

15.1 Management attitude to a bid
Every group is potentially subject to takeover, and clearly, as with any asset,
there will be a price at which the owners (shareholders) may be induced to
sell their shares.
A problem arises, however, where a publicly quoted group, with a widely

spread shareholding, receives an unwelcome (‘predatory’) bid, with the clear
objective of buying the group at a price below the value that management
put on it. It is important to emphasize that this is a management, as opposed
to shareholders’, view, since presumably the latter, if they are induced to
sell, will be happy with the transaction, on the ‘willing buyer, willing seller’
assumption.
It is also important to determine management’s motives in defending a bid

strongly, ie, whether its intention is genuinely to obtain the best price for the
shares, and prevent them being sold below their intrinsic value, or merely to
maintain the group’s independence at any price – which may not be the best
solution for shareholders.
15.2 Non-financial considerations

Two further reasons for strong resistance arise from time to time, regardless
of the financial benefits to shareholders:
(a) Monopoly. This is generally defined by reference to laws regulating

market shares but can also involve any transaction above a defined size.
(b) Employee interest. It is occasionally argued that employment will be

more secure if the group remains independent than it would be under a new
employer whose objectives may be major rationalisation/divestment, which
may include reductions in the workforce.
The emphasis of current political attitudes to corporate law is increasingly on

the rights of employees as well as shareholders, and so employment
consideration may well become increasingly important in the future.
15.3 Reasons for predatory bids

The circumstances under which a predator may seek to buy a group at less
than full value are usually as follows:
(a) The share price is depressed. This can usually be identified by:
(i) the group’s market value being below the net value of its shareholders’
funds; or
(ii) the group’s price/earnings ratio being below, or its yield being above that
for its sector.
In this case, however, the predator may believe that under its management
the group can recover and perform much better financially than under
existing management.
(b) The group’s prospects are better than the share price would indicate. A
period of fluctuating profits may be about to be followed by a good recovery.
A predator might recognize this before it became apparent to the stock
market as a whole, and seek to capitalize on the opportunity.
(c) The group occupies a strong position in one or more markets. The
predator may see the acquisition of the group as a unique opportunity to
purchase a major market share, and wish to do so without paying the market
premium which should, in theory, attach to such a one- off situation.
The purpose of corporate defence is, therefore, either to obtain a full and
satisfactory price from an unwelcome bidder, or to ward off the bid, and
remain independent. It would also seek to ward off the bid if it felt that
national economic interest, as defined by law, or employees’ interests might
be seriously threatened.
16 Strategic defense
The principal aim of strategic defense is to try to eliminate, as far as
possible, the attractions of the group to a would-be predator.
(a) Share price maximization
It is clear from above that a depressed share price, either from fundamental
business difficulties, or where a recovery may be shortly forthcoming which
has not yet been recognized by the market, is a major attraction for
predators.
The fundamental causes of a depressed share price are poor or patchy

profitability, however measured, and/or uncertainties about the future of the
group.
Clearly a vital management objective is to maximize return on investment in

whichever way this is defined. It is often possible to enhance this return by
identifying assets or business units which do not conform to certain minimum
profitability criteria. Elimination of such low returns can enhance the share
price level substantially, and should receive priority from a management
seeking a strong defensive position.
The elimination of business uncertainties is also important. These

uncertainties will principally concern any area of the group’s trading –
market, production, etc – where there are doubts affecting profitability. It is
first of all necessary to identify the uncertainties, and then to seek to allay
them, either by management action or, where the doubts are unjustified, by
convincing the public that the uncertainties do not exist.
(b) The importance of group strategy
A great strength in this regard is the existence of an agreed and well-

understood group strategy, complemented by divisional strategies further
down the line. Provided the strategy is communicated effectively externally
and is well understood, and provided group action and results can be judged
in the light of its existence, it will reassure shareholder and tend to maintain
the share price. Furthermore, it should nominate specifically the approach to
any major ongoing uncertainties.
(c) Communication
In addition, a group may be vulnerable when recovery may be about to take

place after period of low profitability or losses. It should, therefore, work
hard to communicate this potential recovery whilst being careful to give
accurate information and assessment Damage will be caused to the group if
performance does not match the results which the outside world have been
led to expect. The allaying of shareholders’ fears regarding, uncertainties,
and the external communication of group strategy, both point to the
importance of effective financial public relations in seeking to maximize share
price. These can be cultivated in the following-ways:
(i) Use of a good external financial public relations adviser. Such a role
should not i any way substitute for management’s direct communication with
the media, b should complement it, where appropriate, through extending
the range of contact advising on the style and method of communication, and
keeping an ear close to the ground.
(ii) Development of a close relationship with the group’s stockbrokers. The

latter ar usually seen as being a source of good quality information about the
group, an
- they should therefore be provided with all publicly available material, and
have good grasp of the strategy and current trading.
(iii) Development of a close relationship with the stock market research

community ar financial press. Most research analysts have a detailed
knowledge of the market they follow, and an understanding of a group’s
activities and sympathy with i objectives, together with personal relationships
of trust and respect – all of which can be very helpful in external
communications. In addition, many journalists u research analyst contact for
background material for articles.
(iv) Use of press and brokers’ results conferences. Many groups use these
occasions (which usually take place on the day that the preliminary
announcement of interim or final results takes place) formally to restate their
aims and objectives and measure them against their actual trading results.
They provide an opportunity disseminate corporate financial messages to a
wide media audience.
(v) Enhancement of the quality of presentation, and depth of information, of

the annual report. In particular, close attention should be paid to the clarity
and content oft chairman’s statements in the annual and interim reports, and
at the annual gene meeting. These are usually scrutinized and analyzed in
considerable detail.
(vi) Development of direct shareholder relationships. Direct communication
with many shareholders as possible should be sought, through meetings and
visits to group’s facilities. Institutional shareholders, who tend to hold the
majority shares, often take a very passive role but have become increasingly
active in recent years.
(d) Dividend policy
The level of cash dividend is often held to influence share price. Accordingly,
it is argued that an increase in dividend should cause a rise in share price.
However, Chapter 4 has argued that the level of dividend, and thus dividend
policy, should be based fundamentally on the cash flow generation, debt
policy and returns on assets generated by the group. Thus, a change in
dividend without regard to these fundamentals, or changes in them, can only
be a short-term expedient towards share price maximization.
Furthermore, a high dividend payout narrows the scope for large increases in
dividend in the event of a bid. Such a policy, if continued, may actually have
the effect of weakening the group’s defense following a bid.
Achievement of the correct level of dividend, having regard to the

fundamentals, will, however, have the most beneficial effect on share price
over time, and this, in contrast to short-term changes, is of vital significance.
(e) Strategic shareholdings
Another strategic mechanism which is often used is the taking of a large

strategic share stake by a friendly party, or of a cross-shareholding with that
party. This has the advantage that it does, initially at least, deny any
predator a major portion of the equity of the target company.
It does, however, have several disadvantages:
(i) The attitude of an initially friendly shareholder may change, and a

predator may make great efforts to dislodge his shareholding. It may be
more expensive to acquire, but it may prove easier for a bidder to win over
than a lot of small shareholdings.
(ii) Such a shareholding or cross-shareholding may be interpreted as a sign

of weakness and may actually attract predators.
(iii) It is arguable whether such a shareholding, if its object is to prevent any

bid, is in the best interests of shareholders. Furthermore, a cross-
shareholding is often criticized, in that it ties up significant amounts of capital
in both companies.
(f) Maximization of total price payable

It is also argued that, since most predators’ resources are limited, it is worth
maximizing the total price payable, either by a rights issue, or by the
acquisitions of assets for shares or loan stock.
In the case of a rights issue, the value of the equity will be increased, since
the proceeds will initially go to reduce the company’s borrowings in an equal
and opposite amount. However, the defender’s position may be weaker, in
that, if a predator bids on a share-for- share basis, the total borrowings
involved (in this case the internal debt of the target company) would be less.
Under-gearing may in this case prove a substantial weakness since it would
make the target company more attractive.
In the case of an increase in gearing, eg, buying assets in exchange for loan
stock, two negative points apply. ‘First, cash acquisitions causing an increase
in gearing should be consonant with the group strategy: if not, they will
become a waste of financial resource, and may lead to financial weakness
which may even accelerate a bid. Second, if safe gearing limits are thereby
breached, the group creates a further financial risk for itself.
However, high gearing, if within safe. limits, may constitute some form of
defense, in that, in contrast to the above, it will actually increase the total
cash consideration for a share-for- share bidder with limited resources.
(g) Acquisitions by the target company
Finally, acquisitions by the target company may themselves be a wise

strategic defense, though again only if in accordance with group strategy. If
for cash or debt they may increase group gearing, but they may also broaden
the base of the group beyond areas of interest to the predator. If for shares,
they may take the combined market capitalization of the company target
beyond a potential predator’s reach. Further, where limited business areas of
risk or uncertainty are present in group trading, they may reduce the impact
of such risks/uncertainties by lowering the percentage of overall profits on
which they impact.
17 Good housekeeping
There are four elements of good housekeeping which should be observed at
all times.
First, a group should keep a close watch on its share register and share
trading, in order to identify any sinister shareholding buildup at an early
stage. In particular, it should note the following:
(a) Any heavy buying or selling, whether or not it affects the share price.
(b) Any change in ‘major’ shareholdings. ‘Major’ is hard to assess, but a
range from 0.1% to 0.5% of total shares in issue should be considered. It is
probably worth obtaining immediate details of all share transactions down to
a size rather lower than 0.1%.
(c) Any large ‘Sepon’ balance or its equivalent outside the UK. The ‘Sepon’
balance measures the number of shares which have at any time recently
changed hands, but which the new shareholders have not registered. Since
registration may take a while to enforce, it provides a smokescreen for a
would-be predator building up a quiet stake. Any balance over 1% of total
shares on issue (dependent on normal turnover levels in the shares) should
cause an alert.
A group should also make sure its forecasting techniques are effective and
understood throughout its business units. An accurate forecast for at least
the current year’s trading is a vital part of a defense document, and would
normally have to be independently corroborated by a firm of accountants, so
that it should stand up to rigid scrutiny.
Since a takeover offer may quickly follow the acquisition of an initial share
stake as part of a predator’s tactics, it is essential to be able to draft
promptly a document in response, expressing the reasons why, in the
opinion of the board and its advisors, the price which might be offered in the
event of a predatory bid is inadequate.
This document would, inter alia, contain the following:
(a) Comparison of offer price with recent market price of the group,
comments on premium offered, and comparison with net assets. Also,
comment on the disadvantages to remaining shareholders of a sizeable share
stake.
(b) Details of any asset revaluation which might be appropriate.
(c) Comments on current trading, emphasizing recovery and growth situation

in the light of group strategy. Particular attention should be paid to already
identify areas of uncertainty, or where potential exists as yet unnoticed by
the stock market; also to cash generation and gearing effects of current
trading.
(d) Profit and dividend forecast.
(e) Rebuttal of commercial logic of bid, taking each point put forward by
offeror. Also reference, if appropriate, to regulatory environment and
national interest.
An eye should be kept on all likely predators with a view to anticipating their
actions. Clearly, considerations of size (has the relevant candidate the
financial resource to acquire the group?) and industrial synergies will best
determine such a list.
18 The reaction of the target

company
A ‘dawn raid’, i.e., a sudden entry into the stock market by the predator at a
price above the previous market level, with a view to acquiring a major stake
in a short space of time, in that it may lead to a further takeover offer a few
days later, requires a quick reaction. There are a number of key issues to
consider at the outset of a bid. First, board authorities should be obtained
swiftly, and many groups set up a small sub-committee of the board to deal
with urgent matters during the course of a bid, which cannot be referred in
time to the full board. Its authority should, however, be closely circumscribed
by the board. It is usually essential for one senior executive only to be
designated for press contacts.
All bids involve considerable numbers of public statements. Very little, apart
from an outline, can be agreed in advance, although vital holding statements
relating to dawn raids or outright bids can be prepared. The next moves will
depend on circumstances, and in particular on the identity and stated
intentions of the predator.
A particular tactic during an unfriendly/undesired bid is to find a ‘white

knight’, a friendly part who would act in the interests of the defender. Such a
friend might already have taken a share stake. However, this could be a
high risk strategy.
A ‘white knight’ might also, during the course of a bid, make a full counter-
bid, as a more desirable acquirer than the initial predator, or might acquire
shares which can be used in support of the board
It may be desirable to have drawn up a short list of ‘white knights’ in

advance of a bid, but a boad which is confident of its ability to resist a bid
may not wish to compromise its independence I involving other companies.
It is vital to ascertain, as early as possible, but preferably immediately a

predator appears (eg, on same day), what its intentions are. It may be
difficult to draw these out in any detail, but the aim should be to obtain its
plans for the group, how it intends to manage it, fund it and develop it. It is
also important to analyze the predator’s financial and commercial record, as
well as its stated strategy, and the course both before and after’ acquisition
of previous successful takeovers.
19 Anti-takeover mechanisms
Many companies, in a effort to remain independent or to win time to analyze
effectively a takeover bid, have implemented anti-takeover mechanisms.
Examples are:
(a) Poison pill
The most commonly used and seemingly most effective takeover defense is
the so-called poison pill. Examples are:
(i) Flip-in pills involve the granting of rights to shareholders, other than the
potential acquirer, to purchase shares of the target company at a deep
discount. This type of plan will dilute the ownership interest of the potential
acquirer.
(ii) Back-end rights are usually in the form of a cash dividend allowing
shareholders other than the potential acquirer to exchange their shares for
cash or senior debt securities at a price determined by the Board of
Directors. The price set by the Board is usually well in excess of the market
price or the price likely to be offered by a potential acquirer. Because the
price that the target shareholder would receive is likely to be higher than that
offered by the potential acquirer, shares will not be tendered.
(b) Pac Man
Like the video game, the Pac Man defense occurs when a target company
turns around and tries to swallow its pursuer, by use of a counter-tender
offer. Pac Man, while colorful in name, has seldom been used successfully.
(c) Disposal of the Crown Jewels/Scorched Earth
In a ‘disposal of the Crown Jewels’ defense, the target sells the assets which
are of greatest interest to the raider. A more extreme variant of ‘Crown
Jewels’ is the ‘Scorched Earth’ defense. In practical terms, this means that
the target company liquidates all or substantially all of its assets. leaving
nothing to the raider, thereby eliminating the raider’s motive for acquiring
the target.
(d) Fat man
The other side of the ‘Crown Jewels’ and ‘Scorched Earth’ strategies is the
‘Fat man’ defense:
the target company acquires a large and/or underperforming company in
order to decrease its attractiveness to the raider.
(e) Golden parachutes
One tactic that has often been mis-labelled as a takeover defense is the use
of golden parachutes which are, quite simply, severance arrangements for
senior officers of the firm should there be a change in the control. Although a
golden parachute for one Chief Executive Officer involved in a takeover battle
in the USA was reportedly US$35m, they usually are a low multiple of the
most recent year’s salary.
20 Defense document
A vital part of a defense document, which will obviously be prepared with the
group’s merchant bankers, will be the section dealing with the reasons for
preferring the group’s continued independence. This is a topic which, when it
comes to be debated, can prove very controversial and take considerable
time and effort to resolve and draft internally. Accordingly, it seems sensible
to prepare this element of the defense circulars in draft form as soon as
possible, having reached a reasonable consensus.
The section can take the form of a review of the past few years, comparing
strategy and objectives against achievement; and then projecting the
continuing strategy forward. The arguments would then be based on the
requirement for independence to achieve projected strategic objectives.
In particular, the document would examine closely the predator’s intentions,

as previously determined, against the group’s projected strategy and
objectives; and of course it would discuss its ability, real desire and likelihood
of carrying them out.
Such an examination would be the crucial basis for a successful defense. It

should be appreciated that the less a predator has been prepared to say, the
more ammunition he might provide for a victim’s defense against his
predatory bid.
At an appropriate time during the course of the bid, but not necessarily in the
first defense document, a forecast, duly corroborated by an independent firm
of chartered accountants, would normally be presented, for at least the
current year’s trading. This has already been discussed above.
21 Acceptable offers
Any board recognizes that there is a point at which an offer becomes
irresistible, although it would normally be appropriate to offer strong and
logical resistance right up to this point. This is based primarily on price, but
with important considerations being the interests of employees and
customers.
Of course, directors recommending acceptance of a bid clearly have a duty to

make sure that the price is the best available in the circumstances, and that
independence is still not a better course, bearing in mind longer term
considerations. A board can legitimately believe that shareholders may be
financially better off by retaining their shares for a further period, instead of
accepting a takeover offer, however attractive.
22 Issues Influencing the Success

of Acquisitions
22.1 Pre-offer issues
Many acquisitions do not bring the benefits anticipated at the time that the
acquisition was planned. Prospective acquirers should ask themselves the
following questions:
• has the alternative of organic growth been fully

considered?
• have alternative target companies been researched?
• are we paying too much? If involved in a contested bid
with several prospective purchasers, it is better to
withdraw unsuccessfully from the contest than
overpay
• will the key managers in both the ac and acquired
company remain motivated after the takeover?
• will the target company’s future resource needs be
satisfied under its new owners?
22.2 Post-audit and monitoring of post-

acquisition success
All too often a management’s attention turns after an acquisition to planning
the next acquisition rather than ensuring that the newly acquired company
settles in to its new group comfortably.
However lessons can be learned by carrying out a post-audit of the
acquisition some years after the date of the takeover to examine its progress
and compare this with the plan. There are three reasons for undertaking
these analyses:
(a) To discourage managers from spending money on doubtful projects,

because they may be called to account at a later date.
(b) It may be possible over a period of years to discern a trend of reliability

in the estimates of various managers.
(c) A similar project may be undertaken in the future, and then the recently
completed project will provide a useful basis for estimation.
The management writer Drucker has suggested five golden rules for the
process of post-acquisition integration.
Rule 1 Both acquirer and acquiree should share a ‘common core of unity’
including shared technology and markets, not just financial links.
Rule 2 The acquirer should ask ‘What can we offer them?’ as well as ‘What’s
in it for us?’
Rule 3 The acquirer should treat the products, customers etc, of the acquired
company with respect, not disparagingly
Rule 4 The acquirer should provide top management with relevant skills for
the acquired company within a year
Rule 5 Cross-company promotions of staff should happen within one year
23 Strategic Acquisitions
Involving Common Stock
When the acquisition is done for common stock, a “ratio of exchange,” which
denotes the relative weighting of the two companies with regard to certain
key variables, results.
A financial acquisition occurs when a buyout firm is motivated to purchase

the company (usually to sell assets, cut costs, and manage the remainder
more efficiently), but keeps it as a stand-alone entity.
24 Sensible Motives for Mergers
Mergers that take place between two firms in the same line of business are
known as horizontal mergers. Recent examples include bank mergers,
such as Chemical Bank’s merger with Chase and NationsBank’s purchase of
BankAmerica. Other headline-grabbing horizontal mergers include those
between oil giants Exxon and Mobil, and between British Petroleum (BP) and
Amoco.
A vertical merger involves companies at different stages of production. The

buyer expands back toward the source of raw materials or forward in the
direction of the ultimate consumer. An example is Walt Disney’s acquisition
of the ABC television network. Disney planned to use the ABC network to
show The Lion King and other recent movies to huge audiences.
A conglomerate merger involves companies in unrelated lines of

businesses. The majority of mergers in the 1960s and 1970s were
conglomerate. They became less popular in the 1980s. In fact, much of the
action since the 1980s has come from breaking up the conglomerates that
had been formed 10 to 20 years earlier.
With these distinctions in mind, we are about to consider motives for

mergers, that is, reasons why two firms may be worth more together than
apart. We proceed with some trepidation. The motives, though they often
lead the way to real benefits, are sometimes just mirages that tempt unwary
or overconfident managers into takeover disasters. This was the case for
AT&T, which spent $7.5 billion to buy NCR. The aim was to shore up AT&T’s
computer business and to “link people, organizations and their information
into a seamless, global computer network.” It didn’t work. Even more
embarrassing (on a smaller scale) was the acquisition of Apex One, a
sporting apparel company, by Converse Inc. The purchase was made on May
18, 1995. Apex One was closed down on August 11, after Converse failed to
produce new designs quickly enough to satisfy retailers. Converse lost an in
vestment of over $40 million in 85 days.
Many mergers that seem to make economic sense fail because managers
cannot handle the complex task of integrating two firms with different
production processes, accounting methods, and corporate cultures. This was
one of the problems in the AT&T–NCR merger. It also bedeviled Novell’s
acquisition of WordPerfect. That merger at first seemed a perfect fit between
Novell’s strengths in networks for personal computers and WordPerfect’s
applications software. But WordPerfect’s post acquisition sales were horrible,
partly because of competition from other word processing systems but also
because of a series of battles over turf and strategy:
WordPerfect executives came to view Novell executives as rude invaders of

the corporate equivalent of Camelot. They repeatedly fought with. . . Novell’s
staff over everything from expenses and management assignments to
Christmas bonuses. [This led to] a strategic mistake: dismantling a
WordPerfect sales team... needed to push a long-awaited set of office
software products.[3]
The value of most businesses depends on human assets–managers, skilled

workers, scientists, and engineers. If these people are not happy in their new
roles in the acquiring firm, the best of them will leave. One Portuguese bank
(BCP) learned this lesson the hard way when it bought an investment
management firm against the wishes of the firm’s employees. The entire
workforce immediately quit and set up a rival investment management firm
with a similar name. Beware of paying too much for assets that go down in
the elevator and out to the parking lot at the close of each business day.
They may drive into the sunset and never return.
24.1 Economies of Scale

Just as most of us believe that we would be happier if only we were a little
richer, so every manager seems to believe that his or her firm would be more
competitive if only it were just a little bigger. Achieving economies of scale is
the natural goal of horizontal mergers. But such economies have been
claimed in conglomerate mergers, too. The architects of these mergers have
pointed to the economies that come from sharing central services such as
office management and accounting, financial control, executive development,
and top-level management.
The most prominent recent examples of mergers in pursuit of economies of

scale come from the banking industry. The United States entered the 1990s
with far too many banks, largely as a result of outdated regulations on
interstate banking. As these regulations eroded and communications and
technology improved, hundreds of small banks were bought out and merged
into regional or “supra-regional” firms. When Chase and Chemical, two of the
largest money-center banks, merged, they forecasted that the merger would
reduce costs by not 16 percent a year, or $1.5 billion. The savings would
come from consolidating , operations and eliminating redundant costs.
Optimistic financial managers can see potential economies of scale in almost

hat any industry. But it is easier to buy another business than to integrate it
with yours
afterward. Some companies that have gotten together in pursuit of scale

economies still function as a collection of separate and sometimes competing
operations with different production facilities, research efforts, and marketing
forces.
24.2 Economies of Vertical Integration
Vertical mergers seek economies in vertical integration. Some companies try
to gain control over the production process by expanding back toward the
output of the raw material and forward to the ultimate consumer. One way to
achieve this is to merge with a supplier or a customer.
Vertical integration facilitates coordination and administration. Think of an

airline that does not own any planes. If it schedules a flight from Boston to
San Francisco, it sells tickets and then plane for that flight from a separate
company. This strategy might work on a small scale, but it would be an
administrative nightmare for a major carrier, which would have to coordinate
hundreds of rental agreements daily. In view of these difficulties, it is not
surprising that all major airlines have integrated backward, away from the
consumer, by buying and flying airplanes rather than patronizing rent-a-
plane companies.
Do not assume that more vertical integration is better than less. Carried to
extremes, it is absurdly inefficient, as in the case of LOT, the Polish state
which in the late 1980s found itself raising pigs to make sure that its had
fresh meat on their tables. (Of course, in a centrally managed economy it
may be necessary to raise your own cattle or pigs, since you can’t be sure
you’ll be able to buy meat.)
Nowadays the tide of vertical integration seems to be flowing out. C are

finding it more efficient to outsource the provision of many services and
various types of production.
24.3 Surplus Funds

Here’s another argument for mergers: Suppose that your firm is in a mature
industry. It is generating a substantial amount of cash, but it has. few
profitable in vestment opportunities. Ideally such a firm should distribute the
surplus cash to shareholders by increasing its dividend payment or
repurchasing stock. Unfortunately, energetic managers are often reluctant to
adopt a policy of shrinking their firm in this way. If the firm is not willing to
purchase its own shares, it can instead purchase another company’s shares.
Firms with a surplus of cash and a shortage of good investment opportunities
often turn to mergers financed by cash as a way of redeploying their capital.
Some firms have excess cash and do not pay it out to stockholders or
redeploy it by wise acquisitions. Such firms often find themselves targeted
for takeover by other firms that propose to redeploy the cash for them.
During the oil price slump of the early 1980s, many cash-rich oil companies
found them selves threatened by takeover. This was not because their cash
was a unique as set. The acquirers wanted to capture the companies’ cash
flow to make sure it was not frittered away on negative-NPV oil exploration
projects.
24.4 Eliminating Inefficiencies

Cash is not the only asset that can be wasted by poor management. There
are al ways firms with unexploited opportunities to cut costs and increase
sales and earnings. Such firms are natural candidates for acquisition by other
firms with better management. In some instances “better management” may
simply mean the de termination to force painful cuts or realign the
company’s operations. Notice that the motive for such acquisitions has
nothing to do with benefits from combining t firms. Acquisition is simply the
mechanism by which a new management team replaces the old one.
A merger is not the only way to improve management, but sometimes it is

the only simple and practical way. Managers are naturally reluctant to fire or
demote themselves, and stockholders of large public firms do not usually
have much direct influence on how the firm is run or who runs it.
If this motive for merger is important, one would expect to observe that
acquisitions often precede a change in the management of the target firm.
This seems to be the case. For example, Martin and McConnell found that the
chief executive is four times more likely to be replaced in the year after a
takeover than during earlier years. The firms they studied had generally been
poor performers; in the four years before acquisition their stock prices had
lagged behind those of other firms in the same industry by 15 percent.
Apparently many of these firms fell on bad times and were rescued, or
reformed, by merger.
Of course, it is easy to criticize another firm’s management but not so easy

to improve it. Some of the self-appointed scourges of poor management turn
out to be less competent than those they replace. Here is how Warren Buffet,
the chairman of Berkshire Hathaway summarizes the matter:
Many managers were apparently over-exposed in impressionable childhood

years to the story in which the imprisoned, handsome prince is released from
the toad’s body by a kiss from the beautiful princess. Consequently, they are
certain that the managerial kiss will do wonders for the profitability of the
target company. Such optimism is essential. Absent that rosy view, why else
should the shareholders of company A want to own an interest in B at a
takeover cost that is two times the market price they’d pay if they made
direct purchases on their own? In other words
investors can always buy toads at the going price for toads. If investors
instead bankroll princesses who wish to pay double for the right to kiss the
toad, those kisses better pack some real dynamite. We’ve observed many
kisses, but very few miracles. Nevertheless, many managerial princesses
remain serenely confident about the future potency of their kisses, even after
their corporate backyards are knee-deep in unresponsive toads.
The benefits that we have described so far all make economic sense. Other
arguments sometimes given for mergers are dubious. Here are a few of the
dubious ones.
24.5 To Diversify
We have suggested that the managers of a cash-rich company may prefer to
see i use that cash for acquisitions rather than distribute it as extra
dividends. That is why we often see cash-rich firms in stagnant industries
merging their way into fresh woods and pastures new.
What about diversification as an end in itself? It is obvious that diversification
reduces risk. Isn’t that a gain from merging?
The trouble with this argument is that diversification is easier and cheaper for
the stockholder than for the corporation. No one has shown that investors
pay premium for diversified firms; in fact, discounts are common. For
example, Kaiser Industries was dissolved as a holding company because its
diversification apparently subtracted from its value. Kaiser Industries’ main
assets were shares of Kaiser E Steel, Kaiser Aluminum, and Kaiser Cement.
These were independent companies and the stock of each was publicly
traded. Thus you could value Kaiser Industry by looking at the stock prices of
Kaiser Steel, Kaiser Aluminum, and Kaiser Cement. But Kaiser Industries’
stock was selling at a price reflecting a significant discount from the value of
its investment in these companies. The discount vanishes when Kaiser
Industries revealed its plan to sell its holdings and distribute the proceeds to
its stockholders.
Why the discount existed in the first place is a puzzle. But the example at le
shows that diversification does not increase value. The appendix to this
chapter provides a simple proof that corporate diversification does not affect
value in perfect markets as long as investors’ diversification opportunities are
unrestricted
25 Right and Wrong Ways to

Estimate the Benefits of Mergers
Some companies begin their merger analyses with a forecast of the target
firm’s future cash flows. Any revenue increases or cost reductions
attributable to the merger are included in the forecasts, which are then
discounted back to the present and compared with the purchase price:
Estimated net gain = DCF valuation of target including merger benefits -
cash required for acquisition
This is a dangerous procedure. Even the brightest and best-trained analyst

can make large errors in valuing a business. The estimated net gain may
come up positive not because the merger makes sense but simply because
the analyst’s cash- flow forecasts are too optimistic. On the other hand, a
good merger may not be pursued if the analyst fails to recognize the target’s
potential as a stand-alone business. Our procedure starts with the target’s
stand-alone market value (PVB) and concentrates on the changes in cash
flow that would result from the merger. Ask you r self why the two firms
should be worth more together than apart.
The same advice holds when you are contemplating the sale of part of your
business. There is no point in saying to yourself, This is an unprofitable
business and should be sold. Unless the buyer can run the business better
than you can, the price you receive will reflect the poor prospects.
26 Divestitures
In this section, I will briefly discuss the major types of divestitures, in which
corporations sell divisions or other operating units. Types of Divestitures
There are four types of divestitures: (1) sale of an operating unit to another
firm, (2) setting up the business to be divested as a separate corporation and
then “spinning it off’ to the divesting firm’s stockholders, (3) following the
steps for a spin-off but selling only some of the shares, and (4) outright
liquidation of assets.
Sale to another firm generally involves the sale of an entire division or unit,
usually for cash but sometimes for stock of the acquiring firm. In a spin-off,
the firm’s existing stockholders are given new stock representing separate
ownership rights in the division that was divested. The division establishes its
own board of directors and officers, and it becomes a separate company. The
stockholders end up owning shares of two firms instead of one, but no cash
has been transferred. In a carve-out, a minority interest in a corporate
subsidiary is sold to new shareholders, so the parent gains new equity
financing yet retains control. Finally, in a liquidation the assets of a division
are sold off piecemeal, rather than as an operating entity.
26.1 Divestiture Illustrations

1. ‘Pepsi recently spun off its fast-food business, which included Pizza Hut,
Taco Bell, and Kentucky Fried Chicken. The spun-off businesses now operate
under the name Tricon Global Restaurants. Pepsi originally acquired the
chains because it wanted to increase the distribution channels for its soft
drinks, Over time, how ever, Pepsi began to realize that the soft-drink and
restaurant businesses were quite different, and synergies between them
were less than anticipated. The spin off is part of Pepsi’s attempt to once
again focus on its core business. However, Pepsi tried to maintain these
distribution channels by signing long-term contracts that ensure that Pepsi
products will be sold exclusively in each of the three spun- off chains.
2. United Airlines sold its Hilton International Hotels subsidiary to Ladbroke

Group PLC of Britain for $1.1 billion, and also sold its Hertz rental car unit
and its Weston hotel group. The sales culminated a disastrous strategic move
by United to build a full-service travel empire. The failed strategy resulted in
the firing of Richard J. Ferris, the company’s chairman. The move into
nonairline travel-related businesses had been viewed by many analysts as a
mistake, because there were few synergies to be gained. Further, analysts
feared that United’s managers, preoccupied by running hotels and rental car
companies, would not maintain the company’s focus in the highly competitive
airline industry. The funds raised by the divestitures were paid out to
United’s shareholders as a special dividend.
27 Conglomerate Mergers and

Value Additivity
A pure conglomerate merger is one that has no effect on the operations or
profitability of either firm. If corporate diversification is in stockholders’
interests a conglomerate merger would give a clear demonstration of its
benefits. But if present values add up, the conglomerate merger would not
make stockholders better or worse off.
In this section I will examine more carefully my assertion that present value
add. It turns out that values do add as long as capital markets are perfect
and investors’ diversification opportunities are unrestricted.
Let us call the merging firms A and B. Value additivity implies
PVAB = PVA + PVB
where
PVAB = market value of combined firms just after merger;
PVA, PVB = separate market values of A and B just before merger.
For example, we might have
PVA = $100 million ($200 per share x 500,000 shares outstanding)

and
PVB = $200 million ($200 per share X 1,000,000 shares outstanding)
Suppose A and B are merged into a new firm, AB, with one share in AB
exchanged for each share of A or B Thus there are 1,500,000 AB shares
issued If value additivity holds, then PVAB must equal the sum of the separate
values of A and B just before the merger, that is, $300 million That would
imply a price of $200 per share of AB stock
But note that the AB shares represent a portfolio of the assets of A and B
Before the merger investors could have bought one share of A and two of B
for $600. Afterward they can obtain a claim on exactly the same real assets
by buying three shares of AB.
Suppose that the opening price of AB shares just after the merger is $200 so
that PVAB = PVA + PVB Our problem is to determine if this is an equilibrium
price, that is, whether we can rule out excess demand or supply at this price.
For there to be excess demand, there must be some investors who are
willing to increase their holdings of A and B as a consequence of the merger.
Who could they be? The only thing new created by the merger is
diversification, but those investors who want to hold assets of A and B will
have purchased A’s and B’s stock before the merger. The diversification is
redundant and consequently won’t attract new investment demand
Is there a possibility of excess supply? The answer is yes. For example, there
will be some shareholders in A who did not invest in B. After the merger they
cannot invest solely in A, but only in a fixed combination of A and B. Their AB
shares will be less attractive to them than the pure A shares, so they will sell
part of or all their AB stock In fact the only AB shareholders who will not wish
to sell are those who happened to hold A and B in exactly a 1:2 ratio in
their premerger portfolios!
Since there is no possibility of excess demand but a definite possibility of

excess supply, we seem to have
PVAB ≤ PVA + PVB
That is, corporate diversification can’t help, but it may hurt investors by
restricting the types of portfolios they can hold. This is not the whole story,
however, since in vestment demand for AB shares might be attracted from
other sources if PVAB drops below
PVA + PVB
28 Appendix(es)
Application #4 – Estimating
merger gains and costs
Suppose that you are the financial manager of firm A and you want to
analyze the possible purchase of firm B. The first thing to think about is
whether there is an economic gain from the merger.
There is an economic gain only if the two firms are worth more
together than apart. For example, if you think that the combined firm
would be worth PVAB and that the separate firms are worth PVA and PVB, then
Gain = PVAB – (PVA + PVB) = ∆PVAB
If this gain is positive, there is an economic justification for merger. But you
also have to think about the cost of acquiring firm B. Take the easy case in
which payment is made in cash. Then the cost of acquiring B is equal to the
cash payment minus B’s value as a separate entity. Thus
Cost = cash paid - PVB
The net present value to A of a merger with B is measured by the difference

between the gain and the cost. Therefore, you should go ahead with the
merger if its net present value, defined as
NPV = gain - cost
= ∆PVAB - (cash – PVB)
is positive.
I like to write the merger criterion in this way because it focuses attention on
two distinct questions. When you estimate the benefit, you concentrate on
whether there are any gains to be made from the merger. When you
estimate cost, you are concerned with the division of these gains between
the two companies.
An example may help make this clear. Firm A has a value of $200 million,
and B has a value of $50 million. Merging the two would allow cost savings
with a present value of $25 million. This is the gain from the merger. Thus,
PVA = $200
PVB = $50
Gain = ∆PVAB = +$25
PVAB = $275 million
Suppose that B is bought for cash, say, for $65 million. The cost of the
merger is’
Cost = cash paid - PVB
= 65 - 50 = $15 million
Note that the stockholders of firm B–the people on the other side of the
transaction are ahead by $15 million. Their gain is your cost. They have
captured $15 million of the $25 million merger gain. Thus when we write
down the NPV of the merger from A’s viewpoint, we are really calculating
that part of the gain which A’s stockholders stock holders get to keep. The
NPV to A’s stockholders equals the overall gain from the merger less that
part of the gain captured by B’s stockholders: -
NPV = 25 - 15 = +$10 million
Just as a check, let’s confirm that A’s stockholders really come out $10
million ahead. They start with a firm worth PVA = $200 million. They end up
with a firm worth $275 million and then have to pay out $65 million to B’s
stockholders.’ Thus their net gain is
NPV = wealth with merger - wealth without merger
= (PVAB – cash) - PVA
= ($275 - $65) - $200 = +$10 million
Suppose investors do not anticipate the merger between A and B. The

announcement will cause the value of B’s stock to rise from $50 million to
$65 million, a 30 percent increase. If investors share management’s
assessment of the merger gains, the market value of A’s stock will increase
by $10 million, only a 5 percent increase.
It makes sense to keep an eye on what investors think the gains from
merging are. If A’s stock price falls when the deal is announced, then
investors are sending the message that the merger benefits are doubtful or
that A is paying too much for them.
29 References
1. Leveraging the Rewards of Strategic Alliances,” by
Gabor Garai. Journal of Business Strategy,
2. Financial Strategy by AT Foulks Lynch
3. THE JOURNAL Mergers and Acquisitions
4. Principles of corporate Finance by Brealey Myers
5. Financial Management Theory and Practice

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Mergers and Acquisitions

Dr. Glen Brown

It must be recognised that in practice the synergistic gains anticipated from a

Such strategic alliances–whether with competitors, suppliers, vendors, or

Successful collaboration through strategic alliances hinges on spending advance time

In addition, rapid consolidation in vertical industries such as high technology,

Often, however, the window of opportunity is so narrow that it is impossible

1.1 Alliances with growing

A recent alliance between a world-class computer manufacturer and a

1.2 Leveraging Rewards while lowering risks

Because today’s economy is founded on knowledge transfer, alliance-related

Risk also increases in relation to the level of commitment an alliance

• Be specific. Move forward with alliance arrangements only after defining

• Assure shared values. Even if their companies are markedly different,

• Work toward dedicated arrangements. Avoid staffing alliances with

• Move toward permanent knowledge transfer. Whenever possible,

Document with care. Even relatively low-risk ventures such as joint

• Possible conclusion. Documentation is also important when companies

• Reconsider acquisitions. Typically, alliance-related contracts anticipate

2 ARGUMENTS FOR AND AGAINST

Whether by amalgamation or by takeover, the end result may be achieved

(a) transfer of assets; or

(b) transfer of shares

The two methods are summarised below.

TRANSFER OF ASSETS TRANSFER OF

2.2 Rationale for growth by acquisition

2.2.1 Application #1.

Market value of the combined companies (AB) > Market value of A +

It is important to note that synergy is not automatic. In an efficient stock

2.3 Sources of synergy

(a) operating economies;

(b) Market power;

(c) Financial gains; and

We will examine each in turn.

(a) Economies of scale

Horizontal mergers (acquisition of a company in a similar line of business)

(b) Economies of vertical integration

Some acquisitions involve buying out other companies in the same

(c) Complementary resources

It is sometimes argued that by combining the strengths of two companies a

(d) Elimination of inefficiency

2.4 Financial synergy

2.4.1 Application #2.

The following data are available for two companies

Correlation coefficient between returns of A and B = 0.3

Return (assuming no operating economies) = £0.2 + £0.4m= £0.6m

Therefore the value of the combined company should be in excess of £4m

This gives an implied required rate of return of:

Rf+ β(Rm–Rf) = 5%+200(10%–5%)

On total earnings to perpetuity of £0.6m this would give a combined

No increase in value has occurred because no risk reduction has been

From a shareholder’s point of view, in the absence of any operating

(b) Diversification and financing

(c) The ‘boot strap’ or PE game

The following data are available:

Assume company A decided to buy company B at market value on a share

(assuming no synergistic effects) would look something like this:

£3 per share x 2m shares = £6m

The question we need to ask is ‘ In an efficient market why should this

It might do so because of likely future operating economies, but not simply

[(Earnings of Ax PE ratio of A) + (Earnings of B x PE ratio of B)]/( Earnings of

= [(0.2m x 10) + (0.4m x 5]/(0.2m + 0.4m)

30p x 2m shares x6.667 = £4m - i.e., no gain to shareholders.