Chapter 2: Mergers and Acquisitions

Major Finance and Accounting -Dr. Manara Abdelaziz Toukabri-Fall 2021-

Introduction:
Companies enter into merger and acquisition activities for a variety of reasons. Many
companies use mergers as a means to achieve growth. Others seek to diversify their
businesses. In all cases, it is important for corporate executives and analysts to understand
both the motives for mergers and their financial and operational consequences.

I. Mergers and Acquisitions: definitions

Business combinations come in different forms.

A distinction can be made between acquisitions and mergers.

In the context of M&A, an acquisition is the purchase of some portion of one company by
another. An acquisition might refer to the purchase of assets from another company, the
purchase of a definable segment of another entity, such as a subsidiary, or the purchase of an
entire company, in which case the acquisition would be known as a merger.

A merger represents the absorption of one company by another. That is, one of the companies
remains and the other ceases to exist as a separate entity. Typically, the smaller of the two
entities is merged into the larger, but that is not always the case.

Mergers can be classified by the form of integration:

In a statutory merger, one of the companies ceases to exist as an identifiable entity and all
its assets and liabilities become part of the purchasing company.

In a subsidiary merger, the company being purchased becomes a subsidiary of the

purchaser, which is often done in cases where the company being purchased has a strong
brand or good image among consumers that the acquiring company wants to retain.

A consolidation is similar to a statutory merger except that in a consolidation, both

companies terminate their previous legal existence and become part of a newly formed
company. A consolidation is common in mergers where both companies are approximately
the same size.

 The parties to a merger are often identified as the target company and the acquiring
company.

Target Acquiring
compagny compagny

 Mergers are often described more generally as takeovers, although that term is often
reserved to describe hostile transactions, which are attempts to acquire a company
against the wishes of its managers and board of directors.
o A friendly transaction, in contrast, describes a potential business combination
that is endorsed by the managers of both companies, although that is certainly
no guarantee that the merger will ultimately occur.
 An additional way that mergers are classified is based on the relatedness of the
merging companies’ business activities. Considered this way, there are three basic
types of mergers: horizontal, vertical, and conglomerate.
 A horizontal merger is one in which the merging companies are in the same
kind of business, usually as competitors.
One of the clearest examples of horizontal merger is Facebook's acquisition of Instagram in 2012
for a reported $1 billion. Both Facebook and Instagram operated in the same industry (social
media)

Another key example of a horizontal merger was the Walt Disney Company's $7.4 billion acquisition of Pixar
Animation Studios in 2006. Disney had started out as an animation studio that targeted families and children.
But it was facing market saturation with its current operations, along with a sense of creative stagnation.
Pixar operated in the same animation space as Disney, but it had more cutting-edge technology when it
came to digitally animated movies, along with more innovative vision

there is the 1998 merger of two major oil companies, Exxon and Mobil – the biggest in corporate history at the
time, combining the first and second largest energy corporations in the U.S. Officially, Exxon bought Mobil for
$73.7 billion, and the purchase enabled Exxon to gain access to Mobile's gas stations as well as its product
reserves.

 A vertical merger, the acquirer buys another company in the same production
chain, for example, a supplier or a distributor. In addition to cost savings, a
vertical merger may provide greater control over the production process in
terms of quality or procurement of resources or greater control over the
distribution of the acquirer’s finished goods. ―The acquisition by an airline
company of a travel agency would be a vertical acquisition‖.
 Nov 2015: Ikea Buys Romanian, Baltic Forests to
Control Its Raw Materials

Oct 2015: Dell makes $67 on EMC in tech

history's largest acquisition. US computer giant
Dell agrees to buy data storage company EMC

 A conglomerate merger: When an acquirer purchases another company that is

unrelated to its core business. The acquiring firm and the acquired firm are not
related to each other. “General Electric is an example of a conglomerate,
having purchased companies in a wide range of industries, including media,
finance, home appliances, aircraft parts, and medical equipment.‖

II. MOTIVES FOR MERGER

There are typically several motives, both recognized and tacit, behind any given merger.

 Synergy: Among the most common motivations for a merger is the creation of
synergy, in which the whole of the combined company will be worth more
than the sum of its parts. Generally speaking, synergies created through a
merger will either reduce costs or enhance revenues. Cost synergies are
typically achieved through economies of scale in research and development,
manufacturing, sales and marketing, distribution, administration….
 Growth: Growth through M&A activity is common when a company is in a
mature industry.
 Increasing Market Power: When a company increases its market power
through horizontal mergers, it may have a greater ability to influence market
prices. ―Taken to an extreme, horizontal integration results in a monopoly.‖
Vertical integration may also result in increased market power. Vertical
mergers can lock in a company’s sources of critical supplies or create attractive
markets for its products/services.
 Diversification: The idea behind company-level diversification is that the
company can be treated as a portfolio of investments in other companies. Like
a large portfolio, large firms bear less unsystematic risk, so often mergers are
justified on the basis that the combined firm is less risky.
  Managers’ Personal Incentives: Managerialism theories posit that because
executive compensation is highly correlated with company size, corporate
executives are motivated to engage in mergers to maximize the size of their
company rather than shareholder value. Additionally, corporate executives
may be motivated by self aggrandizement. For example, being the senior
executive of a large company conveys greater power and more prestige:
conflict of interest, over confidence…
 Tax Considerations: It is possible for a profitable acquirer to benefit from
merging with a target that has accumulated a large amount of tax losses.
Instead of carrying the tax losses forward, the merged company would use the
tax losses to immediately lower its tax liability. A conglomerate may have a
tax advantage over a single-product firm because losses in one division can
offset profits in another division. (discussion)
 …..

III. TRANSACTION CHARACTERISTICS

M&A transactions can differ along many dimensions, such as the form of acquisition,
financing, timing, control and governance, accounting choices, and numerous details ranging
from the post-merger board composition to the location of the new headquarters.

 The form of acquisition: There are two basic forms of acquisition: An acquirer can
purchase the target’s stock or its assets.
o Stock purchases are the most common form of acquisition. A stock purchase
occurs when the acquirer gives the target company’s shareholders some
combination of cash and securities in exchange for shares of the target
company’s stock. For a stock purchase to proceed, it must be approved by at
least 50 percent of the target company’s shareholders and sometimes more
depending on the legal jurisdiction.
o Asset purchase: the acquirer purchases the target company’s assets and
payment is made directly to the target company. One advantage of this type of
transaction is that it can be conducted more quickly and easily than a stock
purchase because shareholder approval is not normally required unless a
substantial proportion of the assets are being sold, usually more than 50
percent. (?).
 Method of Payment : The acquirer can pay for the merger with cash, securities, or
some combination of the two in what is called a mixed offering. In a cash offering,
the cash might come from the acquiring company’s existing assets or from a debt
issue. In the most general case of a securities offering, the target shareholders receive
shares of the acquirer’s common stock as compensation. Instead of common stock,
however, the acquirer might offer other securities, such as preferred shares or even
debt securities. In a stock offering, the exchange ratio determines the number of
shares that stockholders in the target company receive in exchange for each of their
shares in the target company.
 Mind-Set of Target Management : Mergers are referred to as either friendly or
hostile depending on how the target company’s senior managers and board of directors
view the offer. The distinction is not trivial because a huge amount of time and
resources can be expended by both acquirer and target when the takeover is hostile.
o Friendly Mergers : the acquirer will generally start the process by approaching
target management directly. If both management teams are agreed to a
potential deal, then the two companies enter into merger discussions. The
negotiations revolve around the consideration to be received by the target
company’s shareholders and the terms of the transaction as well as other
aspects, such as the post-merger management structure. Before negotiations
can culminate in a formal deal, each of the parties examines the others’ books
and records in a process called due diligence. The purpose of due diligence is
to protect the companies’ respective shareholders by attempting to confirm the
accuracy of representations made during negotiations. Any deficiencies or
problems uncovered during the due diligence process could have an impact on
negotiations, resulting in adjustments to the terms or price of the deal. If the
issue is large enough, the business combination might be called off entirely.
Once due diligence and negotiations have been completed, the companies enter
into a definitive merger agreement. The definitive merger agreement is a
contract written by both companies’ attorneys and is ultimately signed by each
party to the transaction. The agreement contains the details of the transaction,
including the terms, warranties, conditions, termination details, and the rights
of all parties. Common industry practice has evolved such that companies
typically discuss potential transactions in private and maintain secrecy until the
definitive merger agreement is reached. This trend may have been influenced
 by shifts in securities laws toward more stringent rules related to the disclosure
of material developments to the public. Additionally, news of a merger can
cause dramatic changes in the stock prices of the parties to the transaction.
Premature announcement of a deal can cause volatile swings in the stock prices
of the companies as they proceed through negotiations. After the definitive
merger agreement has been signed, the transaction is generally announced to
the public through a joint press release by the companies. In a friendly merger,
the target company’s management endorses the merger and recommends that
its stockholders approve the transaction. In cases where a shareholder vote is
needed, whether it is the target shareholders approving the stock purchase or
the acquirer shareholders approving the issuance of a significant number of
new shares, the material facts are provided to the appropriate shareholders in a
public document called a proxy statement, which is given to shareholders in
anticipation of their vote. After all the necessary approvals have been
obtained—from shareholders as well as any other parties, such as regulatory
bodies—the attorneys file the required documentation with securities
regulators and the merger is officially completed. Target shareholders receive
the consideration agreed upon under the terms of the transaction, and the
companies are officially and legally combined.
o Hostile Mergers : In a hostile merger, which is a merger that is opposed by the
target company’s management, the acquirer may decide to circumvent the
target management’s objections by submitting a merger proposal directly to the
target company’s board of directors and bypassing the CEO. This tactic is
known as a bear hug. Because bear hugs are not formal offers and have not
been mutually agreed upon, there are no standard procedures in these cases. If
the offer is high enough to warrant serious consideration, then the board may
appoint a special committee to negotiate a sale of the target. Although unlikely
in practice, it is possible that target management will capitulate after a bear hug
and enter into negotiations, which may ultimately lead to a friendly merger. If
the bear hug is not successful, then the hopeful acquirer will attempt to appeal
more directly to the target company’s shareholders. One method for taking a
merger appeal directly to shareholders is through a tender offer, whereby the
acquirer invites target shareholders to submit (―tender‖) their shares in return
for the proposed payment. It is up to the individual shareholders to physically
 tender shares to the acquiring company’s agent in order to receive payment. A
tender offer can be made with cash, shares of the acquirer’s own stock, other
securities, or some combination of securities and cash.. Another method of
taking over a target company involves the use of a proxy fight. In a proxy
fight, a company or individual seeks to take control of a company through a
shareholder vote. Proxy solicitation is approved by regulators and then mailed
directly to target company shareholders. The shareholders are asked to vote for
the acquirer’s proposed slate of directors. If the acquirer’s slate is elected to the
target’s board, then it is able to replace the target company’s management. At
this point, the transaction may evolve into a friendly merger.

IV. TAKEOVERS :
When a target company is faced with a hostile tender offer (takeover) attempt, the target
managers and board of directors face a basic choice. They can decide to negotiate and sell the
company, either to the hostile bidder or a third party, or they can attempt to remain
independent.

Pre-Offer Takeover Defense Mechanisms

 Poison Pills : is a legal device that makes it costly for an acquirer to take control of a
target without the prior approval of the target’s board of directors. Most poison pills
make the target company less attractive by creating rights that allow for the issuance
of shares of the target company’s stock at a substantial discount to market value.
 Incorporation in a State with Restrictive Takeover Laws (United States): In the
United States, many states have adopted laws that specifically address unfriendly
takeover attempts. These laws are designed to provide target companies with
flexibility in dealing with unwanted suitors. Some states have designed their laws to
give the company maximum protection and leeway in defending against an offer
 Staggered Board of Directors: Instead of electing the entire board of directors each
year at the company’s annual meeting, a company may arrange to stagger the terms for
board members so that only a portion of the board seats are due for election each year.
For example, if the company has a board consisting of nine directors, members could
be elected for three year terms with only three directors coming up for election each
year. The effect of this staggered board is that it would take at least two years to elect
enough directors to take control of the board.
 Golden Parachutes: are compensation agreements between the target
company and its senior managers. These employment contracts allow the
 executives to receive lucrative payouts, usually several years’ worth of salary,
if they leave the target company following a change in corporate control.

Post-Offer Takeover Defense Mechanisms

A target also has several defensive mechanisms that can be used once a takeover has already
been initiated.

 “Just Say No” Defense :

 White Knight Defense: Often the best outcome for target shareholders is for the
target company’s board to seek a third party to purchase the company i of the hostile
bidder. This third party is called a white knight because it is coming to the aid of the
target. A target usually initiates this technique by seeking out another company that
has a strategic fit with the target.
 Litigation : A popular technique used by many target companies is to file a lawsuit
against the acquiring company based on alleged violations of securities or antitrust
laws. In the United States, these suits may be filed in either state or federal courts.
Unless there is a serious antitrust violation, these suits rarely stop a takeover bid.
Instead, lawsuits often serve as a delaying tactic to create additional time for target
management to develop other responses to the unwanted offer

The Net present value of a merge:

Firm typically use the NPV analysis when making acquisition (Myres, 1976). The analysis is
relatively straightforward when using cash. The analysis become more complex when the
consideration is stock.

Cash:

Suppose a firm (A) and (B) have values as separate entities of $500 and $100 respective.

If firm (A) acquires firm (B), the merged firm (AB) will have a combined value of $700 due
to synergies of $100.

The board of directors of firm (B) has indicated that it will sell firm (B) if it is offered $150 in
cash. Should firm (A) acquire (B)?

Value of the firm (A) after the acquisition= value of the combined firm-cash

=700-150=550$
Because the firm (A) was worth $500 prior to the acquisition the NPV to firm A shareholders
is : 550-500=50$

Assuming that there are 25share in the firm (A), each share of the firm A worth $20 (500/25)
prior to the merge and 22$ (550/25)after the merge

**looking at the rise in the stock price we conclude that the firm (A) should make the
acquisition

***spoke earlier of both synergy and premium of a merge we can also value the NPV of
merge to the acquirer as

NPV of merge to the acquirer= synergy-premium

Because the value of the combined firm is 700$ and the pre merger values of A and B were
500$ and 100$ respectively, the synergy is $100 (700 –(500+100)) t he premium is 50$ (150-
100)

The NPV of the merger to firm A =100-50=$50

However we must adjust our analysis when discussion Merger.

If the true price of firm A without the merge is 500 the market value of firm A may actually
be above 500 when merger negotiation takes place.

 This occurs because the market price reflects the possibility that the merger will take
place.
 For example, if the probability is 60% that the merger will take place, the market price
of the firm (A)will be:
Market price
(A)=𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡𝑕𝑒 𝑓𝑖𝑟𝑚 𝐴 𝑤𝑖𝑡𝑕 𝑚𝑒𝑟𝑔𝑒𝑟 × 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑚𝑒𝑟𝑔𝑒𝑟 +
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐴 𝑤𝑖𝑡𝑕𝑜𝑢𝑡 𝑚𝑒𝑟𝑔𝑒𝑟 × 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑡𝑦 𝑜𝑓 𝑛𝑜 𝑚𝑒𝑟𝑔𝑒𝑟
= 550 × 0,6 + 500 × 0,4 = 530$

The managers would underestimate the NPV from merger if the market price of firm A is
used.