CORPORATE FINANCE: CFI 311

TOPIC 5. MERGERS & ACQUISITIONS

5.1. Objectives
At the end of this topic the learner should be able to:
 Distinguish between mergers and acquisition
 Explain the different types of mergers
 Discuss the motives for mergers and acquisitions
 Evaluate and advise on merger or acquisition transactions
 Discuss the determinants of success and failure of M&As

5.2. Introduction
Corporate restructuring refers to the changes in ownership, business mix, assets mix and alliances
with a view to enhance shareholder value. Corporate restructuring includes mergers and
acquisitions (M&A), amalgamations, take-overs, leveraged buyouts, spin-offs, share buybacks,
capital reorganisation, sale of business units and assets, etc. Mergers and acquisitions are the most
popular means of corporate restructuring or business combination. Mergers and acquisitions is a
group of deals whose basic objective is to reshape the way a firm works. They are used mostly in
cases where the company is facing growth and hence needs to reorganise itself. In M&A, the
combined expected value of future cash flows of the combination of the two companies involved
should be greater than the sum of the expected cash flows of the two individual companies, in order
to create shareholder value. This may not be the case if a large premium is paid for the target
company. Mergers are rare while are common acquisitions. M&A transactions can be roughly
divided into either mergers or acquisitions.
5.2.1. Mergers versus acquisitions
A merger or an acquisition can be defined as the combination of two or more companies into one
new company. The main difference between a merger and an acquisition lies in the way in which
the combination of the two companies is brought about.
a) Mergers
A merger is any combination that forms one economic unit from two or more previous ones. When
two or more companies agree to combine their operations, where one company survives and the
other loses its corporate existence, a merger is effected. The surviving company acquires all the
assets and liabilities of the merged company. The company that survives is generally the buyer and it
either retains its identity or the merged company is provided with a new name. Mergers usually
involve a process of negotiation between the two firms prior to the combination.
b) Acquisitions
This is an attempt by one firm, called the acquiring firm, to gain a majority interest (over assets or
management) in another firm, called target firm. The effort to control may be a prelude to:
 A subsequent merger or
 Establish a parent-subsidiary relationship or
 Break-up the target firm, and dispose off its assets or
 Take the target firm private by a small group of investors.

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In an acquisition the negotiation process does not necessarily take place between the acquirer and
the target.

Friendly acquisitions
In a friendly acquisition the target is willing to be acquired. The target may view the acquisition as
an opportunity to develop into new areas and use the resources offered by the acquirer. This
happens particularly in the case of small successful companies that wish to develop and expand but
are held back by a lack of capital. The smaller company may actively seek out a larger partner
willing to provide the necessary investment. This kind of acquisition is also referred to as an agreed
acquisition.
Hostile acquisition/ Takeover:
A hostile acquisition is where the target is opposed to the acquisition. Hostile acquisitions are
sometimes referred to as hostile takeovers. In hostile takeovers the acquirer may attempt to buy large
amounts of the target’s shares on the open market.

5.2.2. Objectives of M&A.

M&A may help the firm achieve the following objectives
1) Expansion & growth. 2) Restructuring/down sizing 3) Divestiture/Liquidation of the firm or sell-
off

5.2.3. Classification of M&A transactions.

M&A transactions arise when:
1) The buyer buys the shares, and therefore control, of the target company being purchased.
Ownership control of the company in turn conveys effective control over the assets of the company,
but since the company is acquired intact as a going business, this form of transaction carries with it
all of the liabilities accrued by that business over its past and all of the risks that company faces in its
commercial environment.
2) The buyer buys the assets of the target company. The cash the target receives from the sell-off is
paid back to its shareholders by dividend or through liquidation. This type of transaction leaves the
target company as an empty shell, if the buyer buys out the entire assets. A buyer often structures the
transaction as an asset purchase to "cherry-pick" the assets that it wants and leave out the assets and
liabilities that it does not. This can be particularly important where foreseeable liabilities may
include future, unquantified damage awards such as those that could arise from litigation over
defective products, employee benefits or terminations, or environmental damage.
There is a great deal of confusion and disagreement regarding the precise meaning of terms relating
to business combinations, such as mergers, acquisitions, amalgamation, takeover and consolidation.
Sometimes, these terms are used in broad sense, encompassing most dimensions of business
combinations while sometimes they are defined in a restricted legal sense. The different forms of
combinations are:

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1) Merger.
A merger is the complete absorption of one company by another. The acquiring firm retains its
name and identity and it acquires all of the assets and liabilities of the acquired firm. After a merger,
the acquired firm ceases to exist as a separate business entity. Merger of equals is when the
combining firms are roughly of equal size. Require shareholder approval from both firms.
2) Consolidation:
This is a combination of two or more companies into one new company. Both the acquiring and the
acquired firm terminate their previous legal existence and become part of a new firm. The acquired
firm transfers its assets, liabilities and shares to the new company for cash or exchange of shares.
Requires shareholder approval from both firms.
3) Tender offer.
This is a public offer by one firm to directly buy the shares of another firm at a specific price
(usually above market price). This is made by one firm directly to the shareholders of another firm.
Those shareholders who choose to accept the offer tender their shares by exchanging them for cash
or securities (or both), depending on the offer. A tender offer is frequently contingent on the bidder’s
obtaining some percentage of the total voting shares. The tender offer is communicated to the target
firm’s shareholders by public announcements e.g. on newspaper advertisements and mailings to
shareholders. The acquired firm continues to exist as long as there are minority shareholders who
refuse the tender. However, most tender offers eventually become mergers, if the acquiring firm is
successful in gaining control of the target firm. Tender offers are used to carry out hostile takeovers.
Shareholder approval is not required.
4) Acquisition of assets.
A firm can effectively acquire another firm by buying most or all of its assets. However, the target
will not necessarily cease to exist; it will have just sold off its assets. The target remains a “shell”
company but the assets (most or all) are transferred to the acquiring company. The “shell” will still
exists unless its shareholders choose to dissolve it. Only assets (not stock) is purchased. The buying
company may purchase all or a portion of the assets and pay for them with cash or common stock.
Ultimately, target is liquidated. Shareholder approval is required.
5) Buyout:
The firm can be acquired by its management or a group of institutional investors (e.g. private equity
funds), usually with a tender offer. The acquired firm ceases to exist as a public firm and becomes a
private business. These acquisitions are called management buyout (MBO) if managers are involved
and Leveraged buyouts (LBO) if the funds for the tender offer come predominantly from debt
(mostly junk debt i.e. below investment grade).

5.2.4. Steps in an acquisition

There are four basic and not necessarily sequential steps in acquiring a target firm.
1) Development of a rationale and strategy for doing acquisitions and what understanding of this
strategy requires in terms of resources

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2) Choice of a target for the acquisition and the valuation of the target firm with premiums for the
value of control and synergy.
3) Determination how much to pay on the acquisition, how best to raise funds, & whether to use
stock or cash.
4) Make the acquisition wok after the deal is complete. (This is the most challenging).

5.3. Rationale for corporate mergers and acquisitions.

Why do mergers take place? It is believed that mergers and acquisitions are strategic decisions
leading to maximisation of a company’s growth by enhancing its production and marketing
operations. A number of reasons are attributed for the occurrence of M&As.
i) Synergy.
Synergy refers to the potential additional value from combining two firms, either from operational
of financial sources. Synergies arise from economies realised in a merger where the performance of
the combined firm exceeds that of its previously separate parts. Most mergers take place in order to
increase the value of the combined enterprise. For instance, if Companies X and Y merge to form
Company Z, and if Z’s value exceeds that of X and Y taken separately, then synergy is said to exist
and such a merger should be beneficial to both X and Y’s shareholders. In a synergistic merger, the
post-merger value exceeds the sum of the separate companies’ pre-merger values. However, the
issue of the distribution of the synergistic gains between X and Y’s shareholders is determined by
negotiation between the merging parties. Synergistic gains can be in form of revenue enhancement,
cost reductions or lower taxes. These gains can either be operating or financial synergies.
Operating synergies: are synergies that allow firms to increase their operating income, increase
growth, or both. They are benefits of large scale operations after merger or acquisition. These
synergies come from higher growth or lower costs. They can be categorised as follows:
1) Operating Economies. This refers to enhanced capacity in various key functions accruing to the
larger entity. These result from economies of scale in management, marketing, production or
distribution. Management economies include the combined strengths and experience of the
management of the merging firms. Marketing economies include combined purchasing power after
the merger. Production economies include the sharing of technological know-how about
engineering and manufacturing as well as sharing of infrastructure. Distribution economies include
the shared distribution logistics.
2) Efficiency from improved management. This implies that the management of one firm is more
efficient and that the weaker firm’s assets will be more productive after the merger. Some companies
are inefficiently managed with the result that profitability is lower than it might otherwise be. The
infusion of stronger management and better technology as a result of a merger may enhance
utilization of existing assets in a cost effective manner.
3) Increased market power. This arises from reduced competition following a merger between key
players in an industry. This may facilitate entry into new markets. However, mergers that reduce
competition tend to be controversial as they are socially undesirable and illegal.

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Financial synergies arise from higher cash flows, lower cost of capital, tax savings, etc.
1) Reduction in capital needs. A merger may reduce the combined investments needed by the two
firms. E.g. one firm may want to expand its manufacturing capacity while the other has significant
excess capacity. E.g. a brewing company in need of additional capacity may purchase a brewer that
is suffering from overcapacity.
2) Tax savings. The tax paid by two firms combined together maybe lower than taxes paid by them
as individual firms. Tax benefits can arise either from taking advantage of tax laws or from the use
of net operating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm
may be able to use the net operating losses of the latter to reduce its tax burden Therefore,
combining the two firms can result in tax benefits that can be shared by the two firms that could not
be realized by either firm operating separately.
3) Debt capacity utilisation (leverage gains). Debt capacity can increase, because when two firms
combine, their earnings and cash flows may become more stable and predictable. This in turn,
allows them to borrow more than they could have as individual entities, which creates a tax benefit
for the combined entity (gains from greater financial leverage). This tax benefit can either be shown
as a higher cash flow or take the form of a lower cost of capital for the combined firm.
4) Cash slack/surplus. The combination of a firm with excess cash or cash slack, (and with limited
investment opportunities) and a firm with high-return investment opportunities (and with limited
cash) can yield a payoff in terms of higher value for the combined firm. The increase in value comes
from the projects taken with the excess cash and that would otherwise not have been taken. This
synergy is likely to show up when large firms acquire smaller firms, or when publicly traded firms
acquire private businesses.

ii) Diversification of risk.

Diversification helps stabilize a firm’s earnings and thus benefits owners.
Diversification into unrelated businesses may help a firm spread out risk. Firms may merge to
diversify their operations and thereby reduce their corporate risk. But shareholders can diversify by
purchasing the shares of other companies. Diversification may not create wealth for two publicly
traded firms, with diversified shareholders, but it could create wealth for private firms or closely
held publicly traded firms.
iii) Managers’ personal Incentives.
One would like to think that business decisions are based only on economic considerations,
especially maximization of a firm’s value. However, some business decisions are based more on
managers’ personal motivations than on economic analyses. Many people, including business
leaders, like power, and there is certainly more power attached to running a larger company than a
smaller one. Though no executive would be willing to admit that his or her ego was the primary
reason behind a merger, it appears that egos play a prominent role in many mergers.
iv) Purchase of Assets below their replacement cost.
Sometimes a firm can be touted as an acquisition candidate because the cost of replacing its asset is
considerably higher than its market value. In the case of steel industry it is cheaper to buy an

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existing steel company than to construct a new mill. However the true value of any firm is a
function of its future earning power, not the cost of replacing its assets. Thus, acquisitions should be
based on the economic value of the acquired assets, not on their replacement cost.
v) Market imperfections/undervaluation.
Firms that are undervalued by financial markets, relative to their true value will be targeted for
acquisitions by those who recognise this anomaly.

5.4. Types of Mergers

1) Horizontal Merger
This occurs when one firm combines with another in the same line of business, i.e. they produce the
same type of goods or services. It is also referred to as horizontal integration. The firms compete with
each other in their product markets. Horizontal mergers can create economies of scale, efficiencies
and a more diversified product line. Horizontal mergers are thought to have the greatest potential
anti-competitive effects because they are most likely to eliminate a competitor from the relevant
market.
2) Vertical Merger
This is a merger between a firm and one of its suppliers or customers. It involves firms at different
steps of the production process. It is also referred to as vertical integration. An example would be
when an oil-refining firm acquires a firm that owns oil fields. Vertical mergers may cut the costs of
obtaining and distributing needed materials and ensure their supply. In vertical mergers, the anti-
competitive impact is usually less than in horizontal mergers because the parties are not
competitors.
3) Congeneric/Concentric Merger:
This is a merger in which one firm acquires another firm in the same general industry but is neither
a supplier nor a customer. The merging firms are engaged in related lines of business. In a
congeneric merger, the merging firms may also be connected through technological synergies even
though they belong to different industries. The merger of a pharmaceutical manufacturer producing
anti-ulcer drugs with another producing anti-cancer drugs is an example of a congeneric merger.
These companies would generate synergies but have no overlap between their product lines (i.e.
there is no horizontal integration) and there is no client-supplier relationship (i.e. there is no
vertical integration).
4) Conglomerate Merger:
This is a merger involving companies in totally separate industries. Conglomerate mergers generally
do not pose a danger to competition because the merging companies are not competitors and the
products are not related. In conglomerate mergers, the management structures of the companies
may remain separate because of the different natures of the businesses.

The anticipated operating economies as well as the anti-competitive effects of a merger are partly
dependent on the type of merger involved. Though vertical and horizontal mergers generally
provide the greatest synergistic operating benefits, they are also the ones most likely to be attacked

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by regulators as anti-competitive. However, it is important to think of these economic classifications
when analyzing prospective mergers. In addition, a single merger may be horizontal in some
respects and vertical in others, or it may combine aspects of all categories in some other way. Most
corporate growth occurs by internal expansion, which takes place when a firm’s existing divisions
grow through normal capital budgeting activities. However, the most dramatic examples of growth,
especially in developed economies, result from mergers.

5.5. M&A Analysis

This involves the analysis of benefits and costs associated with a merger or acquisition. When a
company ‘B’ acquires another company say ‘T’, then it is a capital investment decision for company
‘B’ and it is a capital disinvestment decision for company ‘T”. Thus, both the companies need to
calculate the Net Present Value (NPV) of their decisions.
Buyers of a company must determine whether the purchase will be beneficial to them. In order to do
so, they must ask themselves how much the company being acquired is really worth.
The acquiring firm simply performs a capital budgeting decision analysis to determine whether the
present value of the expected cash flows from the merger exceeds the price to be paid for the target
company. If the NPV is positive then the acquiring firm should take steps to acquire the target
company. The Target Company’s shareholders on the other hand should accept the proposal if the
price offered exceeds the present value of cash flows they expect to receive in the future if the firm
continues to operate separately. Both sides of an M&A deal will have different ideas about the worth
of a target company: its seller will tend to value the company at the highest price as possible, while
the buyer tries to get the lowest price possible.
.
5.5.1 Analysing gains/benefits from M&A
A merger will make economic sense to the acquiring firm if its shareholders benefit. A merger will
create economic advantage when the combined value of the merged firms is greater than the sum of
the value of the individual firms as separate entities. Therefore there is need to determine the value
of the combined entity, synergies and the individual firms involved in the deal.
A merger makes sense only if the combined entity’s value (VCE) exceeds the sum of the values of the
separate firms (B & T). i.e.:
VCE > VB + VT, where VB is the value of the Bidder (Acquiring company) & VT is the value of the
Target company.
The benefit from the merger (ΔV)
ΔV = VCE – (VB + VT), When ΔV is positive the acquisition/merger is said to generate synergy.

If firm B buys firm T, it gets a company worth VT + ΔV (incremental gain from the deal).
Let the value of T to B (VT*) = (ΔV + VT)
NPV to the shareholders of the bidder = (VT*) - cost

Valuation methods

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1) Discounted Cash Flow (DCF) method. A key valuation tool in M&A, DCF analysis determines a
company’s current value according to its estimated future cash flows. The cash flows (Net income +
depreciation/amortisation- capital expenditure- change in working capital) are discounted to the
present using the firm’s cost of capital. The firm value should be adjusted for debt if the firm is
leveraged.
2) Stock market valuation. Market capitalisation is used as equity value.
3) Comparable companies/Market multiples (e.g. P/E). This applies a market-determined multiple to
net income, sales, book value, number of subscribers, etc. The acquiring firm makes an offer that is a
multiple of these financial indicators of target firm.
4) Dividend Discount model. This method bases the value of equity value today on the present value
of dividends expected to be paid by the firm.
5) Asset based approach. Equity value = Non-current assets + Net current assets – LT debt

5.5.2. Cost of an acquisition/ Mode of payment

An acquisition or merger involves costs. How much will Bidder pay for Target? Will it be cash or
stock given to target shareholders? Obviously, the bidder tries to buy at the lowest price possible and
the target tries to sell at the highest price possible. The final price is determined by negotiations, with
the party that negotiates best capturing most of the incremental value (synergy).The larger the
synergistic benefits the more room there is for bargaining and the higher the probability that the
merger will actually be concluded. Further, in most cases the acquirer pays a premium and the
amount of premium paid will depend on the mode of payment in the deal. Acquisition premium is
the price paid by an acquiring firm over and above the current value of the target company. There
are three payment modes, Cash, stock or mix of both.
a) Cash acquisition
In cash acquisitions, the shareholders of the target company are paid cash for the shares they own in
the target firm. Thus, the cost of an acquisition when cash is used is the cash paid.
b) Stock acquisition (Stock swap)
In this method, no cash is paid. The acquiring company will have to issue new shares to Target’s
Shareholders, who become shareholders in the new firm. When a merger is financed by stock, the
cost depends on the value of the shares in the new company received by shareholders of the target
company. The value of the merged firm in this case will be equal to pre-merger values of acquiring
and Target firms plus the incremental gain from the merger. The cost in stock acquisitions is
determined by the exchange ratio.
Exchange ratio is the number of the acquiring firm’s shares issued against each target share.
Exchange ratio = No of B Shares: 1 Share of T
The price (exchange ratio) range must be determined i.e. the minimum and maximum price. This is
the basis for negotiations.
Calculating the Exchange Ratio (ER)
ER = value per share of target co / Value per share of acquiring co

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This ratio denotes the relative weighting of the two companies with regard to certain variables.
Thus, the exchange ratio will depend on these two values. There are various ways of calculating the
exchange ratios used in negotiations between the shareholders of the two firms. The two methods
commonly used in calculating the exchange ratio are a) Using stand-alone values and b)
Consideration of synergies.

5.6. Defensive Tactics (especially in the case of hostile takeovers)

Target firm’s managers frequently resists take over attempts. This at times may lead to a higher
premium from the bidding firm. There are a number of defensive tactics
1) Changing the corporate charter: This consists of the articles of incorporation or corporate bylaws
that establish the governance rules of the firm. It establishes the conditions that allow for a take
over. Firms frequently amend the charter, to make acquisitions more difficult. For example, if say
67% (2/3) of the shareholders must approve a merger, then this can be raised to say 80%.
2) Going private and Leveraged Buyouts (LBOs): Going private happens when a publicly owned
firm’s shares in a firm is replaced with complete equity ownership by a private group, which may
include elements of existing management. Consequently, the firm’s shares are taken out of the
market and are no longer traded. One result of going private is that takeovers via tender offer can
no longer occur since there are no publicly held shares. In this sense, a LBO (or more specifically an
MBO-Management BuyOut) can be a takeover defence.
3) Poison pill: This is a tactic designed to repel would be suitors. A financial device designed to make
unfriendly takeover attempts unappealing if not impossible. This can take the form of Share rights
plans, where a priority is give to allow existing shareholders to purchase shares at some fixed price
should an outsider takeover bid come up, discouraging hostile take-over attempts.
4) Golden Parachute: Target firms provide compensation to top-level management if take-over
occurs. This is triggered if the company is taken over.
5) Crown jewel: Firms often sell or threaten to sell major/precious assets (“crown jewels”) when
faced with a takeover threat.
6) White knight: The target firm facing an unfriendly merger offer might arrange to be acquired by
a different friendly firm. 7) Greenmail

5.7. The Post- Deal Performance of Merged Companies

The real work in an acquisition occurs after the transaction. Many studies have examined the extent
to which mergers and acquisitions succeed or fail after the firms combine. Most studies conclude
that many mergers fail to deliver on their promises of efficiency and synergy, and even those that do
deliver seldom create value for the acquirer’s shareholders.
5.7.1. Odds of successes
 Mergers of equals (firms of equal size) seem to have a lower probability of succeeding than
acquisitions of a smaller firm by a much larger firm.
 Cost saving mergers, where cost savings are concrete and immediate, seem to have better
chance of delivering on synergy than mergers based upon growth synergy.

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 Acquisition programmes that focus on buying small private businesses for consolidations
have had more success than acquisition programmes that concentrate on acquiring publicly
traded firms.
 Hostile acquisitions seem to do better at delivering improved post-acquisition performance
than friendly mergers.

5.7.2. Reasons why mergers may fail

There are a several reasons, but the following seem to be the most common:
1) Lack of a post-merger plan to deliver on synergy and control:
Firms in many mergers seem to believe that the value enhancements associated with synergy and
control will arise on their own. In reality, however, firms must plan for and work at creating these
benefits. The absence of planning can be attributed to the fact that firms are seldom concrete about
what form synergy will take and do not try to quantitatively estimate the cash flows associated with
synergy. That is why it is important that firms try to estimate and value synergy, at the time of an
acquisition. Though the estimates are likely to be noisy, the process of thinking about synergy and
putting projections down on paper is the first step in planning.
2) Lack of Accountability:
Closely related to the first problem is a lack of accountability after acquisitions are done. A large
number of people want to be involved in and lay claim to the credit when acquisitions are
announced, far fewer of these individuals want to be held responsible for the post-acquisition work
of delivering on the promises made at the time of the deal. This criticism applies not only to the
managers of the acquiring and target firms, but to their investment bankers as well. The only way to
ensure that the high expectations at the time of the deal come to fruition is to hold those pushing
most strongly for the deal responsible for delivering on its promises.
3) Culture Shock: A firm acquires a culture over time that helps it attract and keep its employees.
When firms merge and try to consolidate, their cultures are likely to come into conflict. If not
managed right, one or both firms will face employee flight and loss of morale. This problem becomes
bigger as firms get larger, and the cultural differences run deeper.
4) Failure to consider external constraints
In valuing control, it is assumed that firms making poor investments would be able to raise their
return on capital and become more productive. This is not always easily accomplished and may
require painful decisions about employee layoffs. In an unconstrained free market, these actions can
be carried out, albeit with significant emotional and economic pain to those involved. More
realistically, firms have to deal with unions and governments that may not take these actions kindly.
In such cases, the firm may be constrained in terms of implementing the actions it had planned to
take.
5) Managerial Egos: In most mergers, the managers at the top of the combining firms have to co-
habit and share power. Although they might do so initially, power struggles often arise between the
chief executives of the combining firms. These disagreements ripple down through the
organizational ranks, leading to a loss of focus on the original motives for the merger.

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6) The Market Price Hurdle: Even the best acquisitions will fail stockholders if the acquiring firm
pays too much for the target firm. When acquiring a publicly traded firm, the acquirer has to pay
the market price plus a premium. To the extent that the market price might already incorporate the
value of synergy or control, and the premium is driven up by rival bids for the target firm, it
becomes difficult to avoid the winner’s curse (the likelihood that the winner in an auction is likely to
overpay for an item he or she bid on. The same phenomenon would apply in acquisitions where
there are multiple bidders for the same target). In M&A the combined expected present value of
future cash flows of the combination of the 2 firms involved should be greater than the sum of the
expected present value of cash flows of the 2 individual companies in order to create shareholder
value. This may not be the case if a large premium is paid for the target firm. This may explain why
acquisitions of private firms, where the premium is not added to a market price, are more likely to
succeed than acquisitions of publicly traded firms.
7) A failure to achieve technological fit.
Technological fit and the failure to achieve it are very common problem areas in mergers and
acquisitions. Companies tend to develop their own technologies and technological approaches to
production over a number of years, and each system tends to be highly individualistic. It can be
extremely difficult to merge two entirely different technological systems. In some cases the costs of
doing so fully would be prohibitively expensive.
8) Shortcomings in the implementation and integration processes.
The most common reason for poor implementation is inadequate planning and control. In mergers
and acquisitions the most common cause of poor implementation is lack of an implementation
driver. Most implementation processes appear to be carried out without an overriding driving force
behind them. The result is that they take longer than originally expected, and the opportunity for
generating and exploiting synergies may be lost as a result.
9) An inability to implement change.
A large-scale merger or acquisition generates a considerable amount of change. In a merger of
equals all sections of each organisation may be subjected to change of varying degrees. Some firms
are better than others at designing and implementing change. In some cases there may be a basic
inability to plan and manage change effectively. In other cases there may be a deep-rooted cultural
opposition to change.

5.8 Role of investment bankers (and financial advisory firms) in M&A

- Help arrange mergers (identify firms with excess cash willing to buy & those willing to be bought)
- Aiding the target company in resisting acquisition
- Help value the target company (help establish a fair price)
- Help in arranging financing for the acquisition

5.9. Leveraged Buyouts

A leveraged buyout is a strategy involving the acquisition of another company using a significant
amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the

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company being acquired, in addition to the assets of the acquiring company, are used as collateral
for the loans. The purpose of leveraged buyouts is to allow companies to make large acquisitions
without having to commit a lot of capital. In an LBO, there is most often a ratio of 70% debt to 30%
equity, although debt can reach as high as 90% to 95% of the target company's total capitalization.
Junk bonds have been routinely used to raise the large amount of debt needed to finance LBO
transactions. Often, the debt will appear on the acquired company’s balance sheet and the acquired
company’s free cash flow will be used to repay the debt. LBOs differ from ordinary acquisitions in
two ways
1) A large fraction of the purchase price is financed by debt
2) The company goes private and its shares no longer trade on the open market.
The LBOs stock is concentrated in the hands of a few investors mainly private equity investors.
When the group of investors is led by the company’s management, the transaction is called a
management buyout (MBO). Valuation of the target company is done considering the potential cash
flows and the ability to repay debt. The main motivation in LBOs is to increase wealth in a short span
of time through restructuring of the acquired firm.

RESOURCE QUESTIONS
1. Distinguish between a merger and an acquisition
2. Expansion is one of the major objectives achieved by through mergers and acquisitions. Uisng
examples discuss this statement.
3. Explain the reasons why firms may merge or acquire others.
4. Distinguish between operating and financial mergers
5. Explain the difference between a friendly and an hostile acquisition
6. a) Discuss the merits of diversification as a rationale for mergers
b) Two large, publicly owned firms are contemplating a merger. No operating synergies are
expected. However since returns on the two firms are not perfectly positively correlated, the
standard deviation of earnings would be reduced for the combined firm. One group of consultants
argues that this risk reduction is sufficient grounds for the merger. Another group of consultants
thinks this type of risk reduction is irrelevant because shareholders can themselves hold the stock
of both firms and thus gain the risk-reduction benefits without all the hassles and expenses of the
merger. Whose position is correct? Explain your answer.
7. What is the difference between i) a merger & a consolidation; ii) Horizontal and vertical merger
8. Which type of merger would generate the highest diversification benefits and why?
9. Firm X is currently valued at sh 300m while firm Y is valued at sh 400m. Firm Y wants to acquire
firm X at a cost of sh 370m. The estimated synergies that would arise from the transaction are
currently valued at sh 50m. i) What is the value of the target to the acquiring company? ii) How
much is the acquisition premium?
10. Firm A has a value of sh 20m and firm B has a value of sh 5m. If the two firms merge cost savings
with a present value of sh 5m would occur. Firm A proposes to offer sh 6m cash compensation to
acquire firm B. Required. Calculate the NPV to shareholders of A and B.

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11. Firms B and T are competitors in very similar businesses. Both are all-equity firms. Each firm will
generate after-tax cash flows of sh. 10M per year forever. Firm B wants to acquire T and merge
their operations. The combined entity would generate after-tax cash flows of sh. 21M per year.
The cost of capital is 10%. a) What is the value of synergies? b) What is the value of the target to
the Buyer?
12. Assume two companies Bidder (B) and Target (T) with the following information
B T
Market value per share sh. 20 sh. 10
No of shares outstanding 25M 10M
Total market value sh. 500M sh. 100M
The estimated incremental value of synergy is sh. 100M.
Company B will acquire T and subsequently merge their operations. The shareholders of the target
company have indicated to a sale if the price offered is Sh.150M payable in cash or stock.
a) Assuming a cash acquisition:
i) Should B acquire T? ii) what is the impact on the acquiring firm’s share value? iii) What is
the acquisition premium? iv) Calculate the NPV to the shareholders of the target firm
b) If it is a stock acquisition:
i) How many new shares will B need to issue to acquire T? ii) what is the impact on the
acquiring company’s share value? iii) Should B acquire T? iv) Calculate the acquisition
premium v) Calculate the NPV to the shareholders of the target firm vi) What is the
exchange ratio?
13. Few Ltd is launching a bid to Dac Ltd. Both companies are quoted and are ungeared. Few Ltd has
100m (par value sh.5) shares outstanding currently selling at sh.20 each. Dac Ltd has 10m
outstanding trading at sh 40 each while their value is sh.5 each. Few Ltd hopes to exploit synergies
worth sh 200m after the takeover. The price offered to Dac Ltd is sh 500m, payable in cash or
stock. Is the deal worthwhile?
14. Company A has 4 m shares outstanding currently selling at sh 10 each. Company B has 5m shares
selling at sh 6 each. a) If A were to acquire B through a stock swap, calculate the exchange ratio
for the deal based on these prices. b) How many new shares will A have to issue to acquire B?
15. LB Ltd is considering the acquisition of CT Ltd. LB Ltd has a current market value of sh 100m
while CT Ltd is valued at sh 50m. If the acquisition occurs, expected economies of scale will result
to savings of sh 2.5m p.a. forever. The required return of both companies and the proposed
combination is 10%. Transaction costs will amount to sh 2m. Required: calculate a) the present
value of the gain from the merger; b) the value that would be created for LB Ltd shareholders if a
cash offer of sh 70m is accepted by CT ltd shareholders.

16. P ltd is currently undertaking a large expansion programme and it is considering the acquisition
of B ltd, a smaller firm. P ltd currently has a stock market value of sh 90m while B ltd has sh 40m.
The management of P ltd expects the acquisition of B ltd to generate significant economies of scale
of cost savings. They expect the market value of the combined entity to sh 158m. To secure the

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required share capital base in B ltd, the management of P Ltd has decided to pay a premium of sh
20m. Additional transaction costs are expected to be sh 5m. The required return on both
companies and the proposed combination is 10%. P Ltd has 45m shares outstanding while B Ltd
has 20m shares. Required:
a) If the management of both firms maximise shareholder wealth and that initial savings will
continue in perpetuity, calculate the present value that would be created by the acquisition.
b) Calculate the price per share if P Ltd decides to pay cash for the shares of B.
c) If shares are offered in a way that B ltd’s shareholders would possess 1/3 of the merged firm,
what value would be created for P ltd’s shareholders?
d) If it’s a cash offer for sh 60m accepted by all shareholders of B, what value is created for P?
e) What reasons may make management of B ltd refuse the offer? f) What defence mechanisms
can B Ltd use?
17. Bella ltd is planning to make an offer for CIC ltd. Shares of CIC are currently selling at sh 30 each.
a) If the tender offer is planned at a premium of 60% over the market price, what will be the value
offered per share of CIC?
b) Suppose before the offer is actually announced the share price of CIC goes to sh 42 because of
strong merger rumours. If you buy the share at that price and the merger goes through (at the
price computed in a above) what will be your percentage gain?
c) Because there is always the possibility that the merger could be called off after it is announced,
you also want to consider your % loss if that happens. Assume you buy the share at sh 42 and it
falls back to its original value after the merger cancellation. What will be your % loss?
d) If there is a 75% probability that the merger will go through when you buy the share at sh 42
and only 25% chance that it will be called off, does this appear to be a good investment? Calculate
the expected value of the return on the investment.
18. What is meant by tender offer? What tactics are used by a target firm to defend itself from a
hostile takeover
19. Firm A wants to acquire firm B. Firm B’s management agrees that the merger is a good idea. Might
a tender offer be used?
20. What is the difference between a spin-off and a sell-off?
21. Discuss the reasons why mergers fail?
22. Explain the meaning of leveraged buyouts. Discuss the attributes of a potential target for a
leveraged buyout
23. Distinguish between a management buyout and a leveraged buyout.
24. CBA Ltd is listed in the stock exchange with 10m shares outstanding trading at sh 20 each. TLC Ltd
wants to acquire CBA Ltd via a leverage buyout and convert it into a private company. TLC Ltd will
have to pay sh 25 for each share of CBA Ltd outstanding. If 10% of the purchase price will come
from TLC’s retained earnings, how much will it need to borrow to acquire CBA Ltd?

14 Dr. Esther Nkatha M