Learning Outcomes

1. Describe key finance goals and decisions and the

environment in which financial decisions are made.
2. Identify and assess ethical issues with respect to financial
theory and practice.
3. Apply time value of money, valuation, and risk and return
techniques to financial decision‐making.
4. Evaluate project and firm cost of capital and demonstrate its
application to financial decisions.
5. Analyse how sound financial management techniques are
Chapter 18: Mergers used to evaluate long and short term investment decisions.
6. Identify and evaluate alternative financing and dividend
An Investment Decision decisions.
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Corporate Restructuring Motives for Merging and Acquisitions

• Merger: a transaction that combines two or
more firms in which the identity of only
one is maintained
• Consolidation: the combination of two or more
firms to form a completely new firm.
• Holding company: a corporation that has voting control of one
or more other corporations
• Subsidiaries: The companies controlled by a holding company
• Maximise shareholder wealth (overriding goal)
• Growth or Diversification: improve market share or the range of
products.
• NZ Yarn welcomes Hemp New Zealand as new strategic partner
• Synergy: post‐merger value > than sum of pre‐merger components.
• Fund Raising: increases capacity to borrow or reduce costs of external
funds.
• Pacific Equity Partners buys Manuka Health
• Tax Considerations.
• Pfizer, Allergan scrap $160b deal after US tax rule change
• Managerial or Technology Skill: Firm has potential but lacks skills,
product or technology to unlock it.
• Scott strengthened by JBS deal

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Motives for Merging and Acquisitions

• Liquidity reasons.
• Defence Against Takeover.
• E.g. 2007 ‐ Nissin Foods launched a friendly 37bn
JBS Takeover yen bid for Myojo Foods after US hedge fund
of Scott Tech
Steel Partners offered 29bn yen to buy Myojo.

• To diversify risk or reduce the cyclical nature of the business.

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 Types of Mergers and Acquisitions Types of Mergers and Acquisitions
• Strategic • Horizontal
• Firms in same line of business.
• Bidder believes there are operating synergies.
• Sky TV / Vodafone merger • Expand operations, eliminate competitor.
• Evolution Healthcare acquisition of private hospital provider Austron
• Financial
• Bidder believes that the price of the target company’s stock is less than
• Vertical
the value of its assets. • Different production stages of same product.
• Gain control over raw materials and / or distribution of finished goods.
• Friendly
• Trilogy‐soars‐on‐boom‐in‐natural‐skincare‐demand‐from‐China
• Acquirer makes offer directly to target’s management or board of
directors.
• Hostile
• Acquirer bypasses target’s management and approaches the
shareholders directly.
• Briscoes hostile take‐over bid for Katmandu

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Types of Mergers and Acquisitions Leveraged Buyouts (LBO's)

• Congeneric • Acquisition funded with a large amount of debt.
• Firms from the same general industry, but with non‐competing
• Debts‐mount‐in‐richest‐Kiwis‐daring‐deal
products.
• May use same sales/distribution channels • A viable candidate for a LBO should have:
• Mighty‐River‐Power‐buys‐solar‐power‐installer‐What‐Power‐Crisis • Solid record of profitability.
• Conglomerate • Low level of debt and assets appropriate as loan collateral
• Stable and predictable cash flows for meeting debt obligations and
• Combining firms from unrelated areas.
working capital.
• Diversification.
• Marlborough lines buys 80% stake in Yealands Wine Group

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Divestures Holding Companies

• Selling or quitting a portion of a firm's assets. • Voting control
• Reasons for divestitures include: • Leverage effect
• Generating cash for expansion. • Pyramiding
• Getting rid of poorly performing operations.
• Risk Protection
• iris‐corp‐to‐divest‐more‐non‐core‐assets‐in‐fy19
• Streamlining the firm. • High administration costs and valuation difficulties
• nz‐retailer‐to‐divest‐its‐finserv‐business‐for‐18‐million
• To be consistent with strategic goals.
• Spin‐off
• A divestiture in which an operating unit becomes an independent
company through the issuance of shares in it, to the parent company’s
shareholders

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 Defences Against Hostile Takeovers Analyzing and Negotiating Mergers
• White Knight: Find a friendly party to mount an opposing bid • Valuing the Target Company
• Greenmail: Offer to buy‐back shares from predators at a • Acquisition of Assets
premium. • Occasionally, a firm is acquired not for its income‐earning potential
• Poison Pill: Make the company unattractive to the bidder. but as a collection of assets that the acquiring company needs
News Corp poison pill • The acquirer must estimate both the costs and the benefits of the
target assets
• Leveraged recapitalisation: Borrow a lot of money and pay the
• This is a capital budgeting problem because the acquirer makes an
shareholders a very large dividend or complete a share initial cash outlay to acquire assets that it expects to generate future
buyback. cash inflows
• Golden parachutes: Contracts entitle management to large
pay‐outs in the event they are made redundant
• Shark repellents: Anti‐takeover clauses in a company's
constitution (prohibited in NZX listing rules)
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Example 1: Asset acquisition decision Example 1: Asset acquisition decision

Zarin Printing is considering the acquisition of Freiman Press at a 1. Calculate the net cost of the large press.
cash price of $60,000. Freiman has liabilities of $90,000. Freiman
has a large press that Zarin needs; the remaining assets would be = – cash price – liabilities + sales proceeds other assets
sold to net $65,000. As a result of the acquisition, Zarin’s cash = – $85,000
flows would increase by $20,000 per year for the next 10 years.
Zarin has a 14% cost of capital. Should Zarin go ahead with the 2. Calculate the NPV of the merger.
merger? n
CFt
NPV = ෍ – CF଴
(1 + r)t
t=1

NPV= $19,322

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Analyzing and Negotiating Mergers Example 2

Cleveland Ltd is interested in acquiring Lewis Ltd in a share swap.
• Stock Swap Transactions Currently, Cleveland is selling for $50 per share. Although Lewis is
• The acquiring firm exchanges its shares for shares of the currently trading at $15.00 per share, the firm’s asking price is $20
target company according to a predetermined ratio per share.
• Ratio of Exchange a) If Cleveland accepts Lewis’ terms, what is the ratio of exchange?
• The ratio of the amount paid per share of the target company to the
market price per share of the acquiring firm Amount paid per share of target firm
Ratio of exchange =
Market price of acquiring firm
• Effect on Earnings per Share
• Initial Effect: The postmerger EPS of the merged firm are often
between the premerger EPS of the two firms = 0.4

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 Example 2 Example 2
b) If Lewis has 20,000 shares issued, how many new shares must
Cleveland Lewis
Cleveland Ltd issue to make the proposed merger? (1) Earnings available for ordinary $200,000 $50,000
shares
Total new shares = No. of target firm shares × ratio of exchange (2) Number of shares outstanding 50,000 20,000
(3) Earnings per share [(1) ÷ (2)] $4 $2.50
= 8,000 new shares
(4) Market price per share $50 $15
(5) Price/earnings (P/E) ratio [(4) ÷ (3)] 12.5 6

c) If the earnings for each firm remain relatively unchanged,

what will the post‐merger EPS be?

Total earnings =
Total number of shares =
EPS = $4.31 per share
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Example 2 Example 2
Cleveland Lewis d) It appears that Lewis’ shareholders have sustained a gain in
(1) Earnings available for ordinary $200,000 $50,000 EPS from $2.50 to $4.31, but because each share of Lewis’
shares original stock is equivalent to 0.4 shares of the merged
(2) Number of shares outstanding 50,000 20,000
company’s stock, the equivalent EPS are actually $1.72 ($4.31 ×
(3) Earnings per share [(1) ÷ (2)] $4 $2.50
0.4). In other words, as a result of the merger, Cleveland’s
(4) Market price per share $50 $15
(5) Price/earnings (P/E) ratio [(4) ÷ (3)] 12.5 6
original shareholders experience an increase in EPS from $4 to
$4.31 to the detriment of Lewis’ shareholders, whose EPS
decrease from $2.50 to $1.72.
d) How much effectively has been earned in EPS on behalf of
each of the original shares i) of Lewis? ii) of Cleveland?
To understand why this happened, we need to look at the P/E
i) $1.72 per share ratio before and after.
ii) $4.31 per share.

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Effect of Price/Earnings (P/E) Ratios on EPS Example 2

Cleveland’s P/E ratio is 12.5, and the P/E ratio paid for Lewis’
Effect on EPS earnings was 8 ($20 ÷ $2.50). Because the P/E paid for Lewis
Relationship between P/E paid and P/E Acquiring company Target was less than the Cleveland P/E (8 versus 12.5), the effect of the
of acquiring company company merger was to increase the EPS for original holders of shares in
P/E paid > P/E of acquiring company Decrease Increase Cleveland (from $4.00 to $4.31) and to decrease the effective
P/E paid = P/E of acquiring company Constant Constant EPS of original holders of shares in Lewis (from $2.50 to $1.72).
P/E paid < P/E of acquiring company Increase Decrease

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4
 Analyzing and Negotiating Mergers
• Stock Swap Transactions
• Long‐run effect on EPS
• The long‐run effect of a merger on the EPS of the merged company
depends largely on whether the earnings of the merged firm grow
• Often, the long‐run effects of the merger on EPS are favorable
because the earnings attributable to the target company’s assets
grow more rapidly than those resulting from the acquiring company’s
premerger assets
Analyzing and Negotiating Mergers
• Stock Swap Transactions Effect on Market Price per
Share
• Ratio of Exchange in Market Price
• Indicates the market price per share of the acquiring firm paid
for each dollar of market price per share of the target firm

where:
MPR = Market Price Ratio of Exchange
MPacquiring = Market Price per Share of the Acquiring Firm
RE = Ratio of Exchange
MPtarget = Market Price per Share of the Target Firm
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Example 2 Example 2
f) If the earnings of the merged firm remain at the premerger
e) The market price of Cleveland’s stock was $50 and that of Lewis levels, and if the stock of the merged firm is expected to sell at
was $15. Cleveland offered a price of $20 to purchase Lewis. The Cleveland’s premerger P/E multiple, then what is the expected
ratio of exchange was 0.4. What market price per share of market price per share of the merged firm?
Cleveland was paid for every $1.00 of market price of Lewis? Cleveland Lewis
(1) Earnings available for ordinary $200,000 $50,000
shares
(2) Number of shares outstanding 50,000 20,000
(3) Earnings per share [(1) ÷ (2)] $4 $2.50
= 1.333 (4) Market price per share $50 $15
(5) Price/earnings (P/E) ratio [(4) ÷ (3)] 12.5 6

New market price = new EPS ×P/E

= $53.88

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Generalisations From Empirical Studies Takeover Regulation

• Stock prices of targets almost always go up. • Takeover regulation typically tries to do one or more of:
• Stock prices of acquirers sometimes go up and sometimes go • Improving the dissemination of timely relevant information
down (depending on the circumstances). • Improving the position of minority (small) shareholders
• Creating an auction system
• The combined market value of the target and acquirer go up,
on average. • Mergers are prohibited under Commerce Act if they have the
• Tendency to observe a “diversification discount”. i.e. being a capacity to allow or strengthen a dominant position in the
conglomerate does not usually add value. market.
• Synergy is often quoted by management as the main reason
for a merger, but most research has found that there is no
consistent synergy effect.
• There is evidence of agency effects.
• There is evidence of hubris effects.
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