Topic 10 Merger and Acquisitions

MFA 8033
FINANCIAL
MANAGEMENT
1
TOPIC 10
Merger & Acquisitions
2
TOPIC LEARNING OUTCOME
 Distinguish the theory and process of

merger and acquisitions.
 Apply the valuation and tools of merger
and acquisitions.
3
CHAPTER 26
MERGERS AND ACQUISITIONS
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
WHAT IS MERGER?
• A merger is an agreement that

combines two separate, existing
companies into a new, larger
entity. The aim of a merger is to
create a stronger, single
company.
26-5
WHAT IS ACQUISITION?
• An acquisition - sometimes referred to as a business

acquisition or a takeover - occurs when one
company takes control of another, either through
purchasing shares or acquiring assets.
• Within an acquisition, the acquired company is

absorbed and no longer operates as an
independent entity; however, the purchasing
company may still have the rights to use the name
and trademarks of the acquired company.
26-6
MERGERS AND ACQUISITIONS
• Mergers and acquisitions (M&A) are defined as

consolidation of companies. Differentiating the two
terms, Mergers is the combination of two
companies to form one, while Acquisitions is one
company taken over by the other. M&A is one of
the major aspects of corporate finance world. The
reasoning behind M&A generally given is that two
separate companies together create more value
compared to being on an individual stand. With
the objective of wealth maximization, companies
keep evaluating different opportunities through the
route of merger or acquisition.
26-7
MERGER TERMS
• The Bidder – the acquiring firm
• The Target Firm – the firm that is sought (and

perhaps acquired)
• The Consideration – cash or securities

offered to the target firm in the acquisition
26-8
Recent Mergers
Payment
Industry Acquiring Company Selling Company ($, billions)
Telecom AT&T TimeWarner 85
Chemicals Dow Chemical DuPont 79
Media Disney 21st Century Fox 71
Pharmacy/Health insurance CVS Health Aetna 69
Agrichemicals Bayer (Germany) Monsanto 66
Eyewear Essilor (France) Luxottica (Italy) 54
Tobacco British American Tobacco (UK) Reynolds American 49
Agrichemicals China National Chemical (China) Syngenta (Switzerland) 43
Semiconductors Qualcomm NXP Semiconductors (Holland) 38
Telecom Comcast Sky (UK) 31
Pharmaceuticals Johnson & Johnson Actelion (Switzerland) 30
Aerospace United Technologies Rockwell Collins 30
Railway transportation equipment Siemens Mobility Division (Germany) Alstom (France) 16
Retailing Amazon Whole Foods 14
21 - 9
Sensible Reasons for Mergers (1 of 6)
 Economies of Scale
– A larger firm may be able to reduce its per unit cost by
using excess capacity or spreading fixed costs across
more units
Reduces costs
$ $ $
Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 21 - 10

 Economies of Vertical Integration

– Control over suppliers “may” reduce costs
– Over integration can cause the opposite effect
Pre-integration Post-integration
(less efficient) (more efficient)
Company Company
S
S S
S S
S S
S
 Combining Complementary Resources

– Merging may result in each firm filling in the “missing
pieces” of their firm with pieces from the other firm
Firm A
Firm B

 Mergers as a Use for Surplus Funds

– If your firm is in a mature industry with few, if
any, positive NPV projects available,
acquisition may be the best use of your funds

 Elimination of Inefficiencies
– Poor management may waste money, make poor
decisions, conduct improper risk/return investments
and harm the value of the company
– Sometimes, the only way to remedy the situation is to
change management

 Industry Consolidation
– The biggest opportunities to improve efficiency seem
to come in industries with too many firms and too
much capacity
– These conditions often trigger a wave of mergers and
acquisitions, which then force companies to cut
capacity and employment and release capital for
reinvestment elsewhere in the economy

MERGER VS. CONSOLIDATION
• Merger
 One firm is acquired by another.
 Acquiring firm retains name and acquired firm
ceases to exist.
 Advantage – legally simple
 Disadvantage – must be approved by
stockholders of both firms
• Consolidation
 Entirely new firm is created from combination of
existing firms.
26-16
ACQUISITION OF STOCK
• A firm can be acquired by another firm or

individual(’s) purchasing voting shares of the firm’s
stock.
• Tender offer – public offer to buy shares made
directly by the bidder to target firm shareholders
 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.
 If not enough shares are tendered, then the offer
might be withdrawn or reformulated.
26-17
ACQUISITION OF STOCK (CTD.)
• Stock acquisition versus a merger
 No stockholder vote required with stock acquisition
 Can deal directly with stockholders in a stock acquisition,
even if management is unfriendly
 Resistance by the target firm’s management often makes
the cost of acquisition by stock higher than the cost of a
merger.
 Often, a significant minority of shareholders will hold out in
a tender offer, which will usually increase the cost and time
required for a merger.
 Complete absorption of one firm by another requires a
merger.
 Many acquisitions by stock are followed up with a formal
merger later.
26-18
ACQUISITION OF ASSETS
• A firm can acquire another firm by buying most or all of its

assets.
• In this case, the target firm still exists unless the stockholders
choose to dissolve it.
• This type of acquisition requires a formal vote of the

shareholders of the selling firm.
• One advantage of an asset acquisition is that there is no

problem with minority shareholders holding out.
• One disadvantage of an acquisition of assets may involve

transferring titles to individual assets, which can be very costly.
26-19
CLASSIFICATIONS OF
ACQUISITIONS
• Three types of acquisitions according to
financial analysts:
 Horizontal – both firms are in the same industry
 Vertical – firms are in different stages of the production

process
 Conglomerate – firms are unrelated
26-20
TAKEOVERS
• Takeover - control of a firm transfers from one group to
another
• Possible forms of a takeover:
1. Acquisition
• Merger or consolidation
• Acquisition of stock
• Acquisition of assets
2. Proxy contest - an attempt to gain control of a firm by

soliciting a sufficient number of stockholder votes to
replace existing management
3. Going private - transactions in which all publicly owned
stock in a firm is replaced with complete equity
ownership by a private group
26-21
GOING PRIVATE
• Leveraged buyouts (LBOs): going-private

transactions in which a large percentage of
the money used to buy the stock is
borrowed
26-22
LEVERAGED BUY-OUTS
• Uniq
• ue Features of LBOs
Large portion of buy-out
financed by debt
Shares of the LBO no longer

trade on the open market
26-23
LEVERAGED BUY-OUTS (2 OF 3)
Leveraged buyout Management buyout

(LBO) (MBO)
Acquisition of the firm Acquisition of the firm by
by a private group using its own management in
substantial borrowed a leveraged buyout
funds
26-24
DIVESTITURES, SPIN-OFFS, AND CARVE
OUTS
• Divestiture
 When a firm sells some of the assets to another
entity as a going concern
• Spin Off
 The process of a business separating the ongoing
operations of a unit of that business and giving
the shareholders of the parent firm shares of the
unit. The unit and parent function as separate
entities.
• Carve Outs
 Similar to a spin off, but the carve out issues
shares of the new firm to the public 26-25
ALTERNATIVES TO MERGER
• Strategic alliance: agreement between

firms to cooperate in pursuit of a joint goal
• Joint venture: typically an agreement

between firms to create a separate, co-
owned entity established to pursue a joint
goal
26-26
TAXES AND ACQUISITIONS
• Tax-free acquisition
 Business purpose; not solely to avoid taxes
 Continuity of equity interest – stockholders of target
firm must be able to maintain an equity interest in the
combined firm
 Generally, stock for stock acquisition
• Taxable acquisition
 Firm purchased with cash
 Capital gains taxes – stockholders of target may
require a higher price to cover the taxes
 Assets are revalued – affects depreciation expense
26-27
BENEFITS AND COSTS OF MERGERS
• Who Usually Benefits from the Merger?

 Shareholders of the target
 Lawyers and brokers
 The executives of the acquiring firm
• Who Usually Loses in a Merger?
 Shareholders of the acquirer due to
overpayment
 Executives on the target
 All employees due to restructuring
26-28
GAINS FROM ACQUISITIONS
• There are a number of possible reasons why

a target firm will somehow be worth more in
our hands than it is worth now.
• To determine the gains from an acquisition,

we need to first identify the relevant
incremental cash flows, or, more generally,
the source of value.
26-29
SYNERGY
• Synergy is the positive incremental net gain

associated with the combination of two
firms through a merger or acquisition.
• Synergy is generally a good reason for a

merger.
• Firms must examine whether the synergies

create enough benefit to justify the cost.
26-30
POTENTIAL SOURCES OF SYNERGY
• From earlier chapters, the incremental cash flow,

ΔCF, can be broken down into four parts:
ΔCF = ΔEBIT + ΔDepreciation

+ ΔTax – ΔCapital requirements
ΔCF = ΔRevenue – ΔCost

– ΔTax – ΔCapital requirements
• The merger will make sense only if one or more of

these cash flow components are beneficially
affected by the merger.
26-31
POTENTIAL REVENUE
ENHANCEMENT
• Marketing gains
 Improving advertising
 Improving the distribution network
 Improving an unbalanced product mix
• New strategic benefits
• Increasing market power
26-32
POTENTIAL COST REDUCTIONS
• Economies of scale
 Ability to produce larger quantities while
reducing the average per unit cost
 Most common in industries that have high fixed
costs
• Economies of vertical integration

 Coordinate operations more effectively
 Reduced search cost for suppliers or customers
• Complimentary resources
26-33
POTENTIALLY LOWER TAXES
• Take advantage of net operating losses.
 Carryforwards (carrybacks were eliminated by
the Tax Cuts and Jobs Act of 2017)
 Merger may be prevented if the IRS believes the
sole purpose is to avoid taxes.
• Unused debt capacity
• Surplus funds
 Pay dividends
 Repurchase shares
 Buy another firm
• Asset write-ups 26-34
POTENTIAL REDUCTIONS IN
CAPITAL NEEDS
• A merger may reduce the required investment
in working capital and fixed assets relative to
the two firms operating separately.
• Firms may be able to manage existing assets

more effectively under one umbrella.
• Some assets may be sold if they are redundant

in the combined firm (this includes reducing
human capital as well).
26-35
AVOIDING MISTAKES
• Do not rely on book values alone – the

market provides information about the true
worth of assets.
• Estimate only incremental cash flows.
• Use an appropriate discount rate.
• Be aware of transaction costs – these can

add up quickly and become a substantial
cash outflow.
26-36
INEFFICIENT MANAGEMENT
• Some firms could see a value increase with a

change in management.
• These are firms that are poorly run or otherwise do

not efficiently use their assets to create shareholder
value.
• Mergers are a means of replacing management in

such cases.
26-37
FINANCIAL SIDE EFFECTS OF
ACQUISITIONS
• Financial side effects of a merger may occur
regardless of whether the merger makes economic
sense or not.
• Two such possible effects:

 EPS growth
 Diversification
26-38
EPS GROWTH
• Mergers may create the appearance of growth in

earnings per share.
• If there are no synergies or other benefits to the

merger, then the growth in EPS is just an artifact of
a larger firm and is not true growth.
26-39
DIVERSIFICATION
• Diversification, in and of itself, is not a good

reason for a merger.
• Stockholders can normally diversify their

own portfolio cheaper than a firm can
diversify by acquisition.
• Stockholder wealth may actually decrease

after the merger because the reduction in
risk, in effect, transfers wealth from the
stockholders to the bondholders.
26-40
COST OF AN ACQUISITION
• Method 1: CASH ACQUISITION

 The cost of an acquisition when cash is used is
just the cash itself.
 The cash cost largely determines whether the
merger will be able to create value.
• Method 2: STOCK ACQUISITION

 In a stock merger, no cash actually changes
hands.
 Instead, the shareholders of the target firm come
in as new shareholders in the merged firm.
26-41
CASH VS. STOCK ACQUISITION
• Cost of Stock Acquisition

 Depends on the number of shares given to the target
stockholders
 Depends on the price of the combined firm’s stock
after the merger
• Considerations when choosing between cash and

stock
 Sharing gains – target stockholders don’t participate
in stock price appreciation with a cash acquisition
 Taxes – cash acquisitions are generally taxable
 Control – cash acquisitions do not dilute control
26-42
DIVESTITURES AND
RESTRUCTURINGS
• Divestiture – company sells a piece of itself to
another company
• Equity carve-out – company creates a new

company out of a subsidiary and then sells a
minority interest to the public through an IPO
• Spin-off – company creates a new company out of

a subsidiary and distributes the shares of the new
company to the parent company’s stockholders
• Split-up – company is split into two or more

companies, and shares of all companies are
distributed to the original firm’s shareholders 26-43
COMPREHENSIVE PROBLEM
• Two identical firms have yearly after-tax cash flows

of $20 million each, which are expected to
continue into perpetuity. If the firms merged, the
after-tax cash flow of the combined firm would be
$42 million. Assume a cost of capital of 12%.
 Does the merger generate synergy?
 What is change in overall firm value from the merger?
 What is the value of the target firm to the bidding

firm?
26-44
END OF CHAPTER
CHAPTER 26
26-45

Topic 10 Merger and Acquisitions

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MFA 8033

Merger & Acquisitions

 Distinguish the theory and process of

• A merger is an agreement that

• An acquisition - sometimes referred to as a business

• Within an acquisition, the acquired company is

• Mergers and acquisitions (M&A) are defined as

• The Bidder – the acquiring firm

• The Target Firm – the firm that is sought (and

• The Consideration – cash or securities

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 21 - 10

 Economies of Vertical Integration

 Combining Complementary Resources

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 21 - 12

 Mergers as a Use for Surplus Funds

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 21 - 13

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 21 - 14

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 21 - 15

• A firm can be acquired by another firm or

• A firm can acquire another firm by buying most or all of its

• This type of acquisition requires a formal vote of the

• One advantage of an asset acquisition is that there is no

• One disadvantage of an acquisition of assets may involve

 Horizontal – both firms are in the same industry

 Vertical – firms are in different stages of the production

 Conglomerate – firms are unrelated

2. Proxy contest - an attempt to gain control of a firm by

• Leveraged buyouts (LBOs): going-private

Shares of the LBO no longer

Leveraged buyout Management buyout

• Strategic alliance: agreement between

• Joint venture: typically an agreement

• Who Usually Benefits from the Merger?

• There are a number of possible reasons why

• To determine the gains from an acquisition,

• Synergy is the positive incremental net gain

• Synergy is generally a good reason for a

• Firms must examine whether the synergies

• From earlier chapters, the incremental cash flow,

ΔCF = ΔEBIT + ΔDepreciation

ΔCF = ΔRevenue – ΔCost

• The merger will make sense only if one or more of

• New strategic benefits

• Increasing market power

• Economies of vertical integration

• Firms may be able to manage existing assets

• Some assets may be sold if they are redundant

• Do not rely on book values alone – the

• Estimate only incremental cash flows.

• Use an appropriate discount rate.

• Be aware of transaction costs – these can

• Some firms could see a value increase with a

• These are firms that are poorly run or otherwise do

• Mergers are a means of replacing management in

• Two such possible effects:

• Mergers may create the appearance of growth in

• If there are no synergies or other benefits to the

• Diversification, in and of itself, is not a good

• Stockholders can normally diversify their

• Stockholder wealth may actually decrease

• Method 1: CASH ACQUISITION

• Method 2: STOCK ACQUISITION

• Cost of Stock Acquisition

• Considerations when choosing between cash and