14-Jan-21

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

FUNDAMENTALS OF M&A

Varieties of Takeovers
Takeovers: an act of assuming control of something, especially the
buying out of one company by another.

Merger/Consolidation

Acquisition Acquisition of Stock

Takeovers Proxy Contest Acquisition of Assets

Going Private
(LBO)

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The basic forms of acquisitions

• Acquisition: one company acquires another companies, usually one
company is bigger than the other

• There are three basic legal procedures that one firm can use to
acquire another firm:
• Merger or Consolidation

• Acquisition of Stock

• Acquisition of Assets

Merger vs Consolidation

• Merger
o One firm is acquired by another
o Acquiring firm retains name and acquired firm ceases to exist
o Advantage – legally simple
o Disadvantage – must be approved by stockholders of both firms
o Statutory merger vs voluntary merger

• Consolidation
o Entirely new firm is created from combination of existing firms

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Merger

Merger of Equals – two companies of equal size

• Usually one company ends up being the dominant one

Example: Daimler merger of equals with Chrysler (1998)

o Here Daimler acquired Chrysler

o Kerkorian sued and said not a merger of equals but an acquisition and if so he
wanted his premium

o He lost this suit

Merger (cont.)
•Statutory merger – legal name given to mergers
o Specifically means that it is a merger pursuant to state laws in which the
acquirer is incorporated
o The normal process is an agreed upon deal between the two companies
•Subsidiary merger – a merger of two companies in which the target becomes a
subsidiary.
o May allow the buyer to keep the target as a separate subsidiary corporation and
insulate the parent company from the target’s liabilities

o Example: GM acquired EDS and made it a subsidiary and issued Class E

shares. The same happened with Hughes Aircraft

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Terminology (cont.)

Offer – where a bidder makes an offer directly to the target

• Tender
company’s shareholders
• Usually done in hostile deals

Terminology
• Leverage buyout (LBO): an acquisition using a significant amount of debt to
meet the cost of acquisition.

• Management buyout (MBO): A form of acquisition where a company’s

existing managers acquire a large part or all of the business entity.

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Terminology

• Acquisition: the purchase of a business entity, entities, an asset, or assets.

➢Acquisition of assets: where all or a selected portion of the assets (e.g.,
inventory, accounts receivable, and intellectual property rights) of the Target
are sold to the Buyer or a subsidiary of the Buyer. In an asset purchase, all
or a selected portion or none of the liabilities and obligations of the Target
are assumed by the Buyer.
➢Acquisition of equity: the outstanding stock of the Target is sold to the Buyer
or a subsidiary of the Buyer by the shareholders of the Target.

Asset Purchases

• Asset Purchase (Alternative to Stock Purchase)

• Important Issue: Treatment of liabilities
• Note: Corporation could sell off all assets and then pay a liquidating dividend and
dissolve the corporation
o Liabilities: Must be satisfied
• Liabilities and Acquisitions: Buyer assumes both the assets and
liabilities of the seller
o Successor liability: Attempts to avoid such liabilities that may give rise to a
lawsuit for a Fraudulent Conveyance of Assets

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Holding Companies

• Parent company owns sufficient stock in target to control target

o Usually can be achieved for less than 51%

o May be as low as 10%

• An alternative to 100% acquisition

Holding Companies (cont.)

• Advantages:
o Lower cost – do not have to buy 51% or 100%
o No control premium
o May get control without soliciting target shareholder approval

Disadvantages:
➢ Triple taxation of dividends
- If parent owns 80% or more dividends are exempt from taxation
- If own less than 80% then 80% of dividends are
exempt from tax
➢ Easier to disassemble if Justice Department finds:
- Antitrust
- Anticompetitive Problems

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Joint Ventures

• Alternative to a merger or acquisition

• May allow the bidder to accomplish the goals it has in mind without incurring
the costs of a complete acquisition of the target

• These goals may be:

o Enter a new market

o Lock up a source of supply
o Develop a new product
o Preempt competitors from achieving a certain goal

Joint Ventures (cont.)

•Biotech companies use modern drug development techniques

•Pharmaceutical companies are able to manufacture and market the new

drugs while biotechnology companies develop them – doing the R&D

•The pharmaceutical manufacturers may also provide the R&D capital

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Strategic Alliances

❑ Advantages:
• May be more flexible than joint ventures
• They come in wide varieties
• May enable companies to pursue goals without a large financial
commitment
❑ Disadvantages:
• Greater opportunities for opportunistic behavior by merger
partners
• Could lose valued know-how

Strategic Alliances (cont.)

•Common in the airline industry

•International
air carriers join their networks together so as to be able to
offer many destinations in a seamless manner
•One flight can have different flight numbers – different ones used by each
carrier

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Acquisition methods

• Cash
• Stock
• Notes

Structuring considerations: overview

• Tax
o 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
o Taxable acquisition
- Firm purchased with cash
- Capital gains taxes where applicable – stockholders of target may require a higher
price to cover the taxes
- Assets are revalued – affects depreciation expense
• Corporate Law
• Securities law
• Antitrust and other regulatory considerations
• Acquisition accounting

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Motivations for Acquisitions

• In efficient markets, M&A should only occur when two firms are worth
more combined than as separate entities
• Concept of “Synergy” - the whole is worth more than the sum of the parts
(2 + 2 = 5!)
• Some mergers create synergies because the acquiring firm can either cut
costs or use the combined assets more effectively
• This is generally a good reason for a merger
• Examine whether the synergies create enough benefit to justify the cost
paid

Synergy

• Suppose firm A is contemplating acquiring firm B.

• The synergy from the acquisition is
Synergy = VAB – (VA + VB)
• The synergy of an acquisition can be determined from the standard
discounted cash flow model:

S
DCFt
T

Synergy = (1 + R)t
t=1

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Value of new merged firm = PVAB = $250 million

Pre-merger
Value of B Synergistic
Pre-merger value of A
= PVB = Gains =
= PVA = $100 million
$75 million $75 million

Combined value of individual firms =

PVA + PVB = $175 million

Sources of Synergy

• Revenue Enhancement
• Cost Reduction
o Replacement of ineffective managers
o Economy of scale or scope

• Tax Gains
o Net operating losses
o Unused debt capacity

• Incremental new investment required in working capital and fixed assets

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Dubious Reasons for Acquisitions

• Earnings Growth
• 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 (i.e., an accounting illusion).
• Diversification
• Shareholderswho wish to diversify can accomplish this at
much lower cost with one phone call to their broker than can
management with a takeover.

EPS Growth

• Mergers may create the appearance of growth in earnings per share (EPS)
– “side effects”
• If there are, in fact, no synergies or other benefits to the merger then the
growth in EPS is artificial rather than true growth
• In this case, the P/E ratio should fall because the combined market value
should not change
• There is no “free lunch” if markets are efficient

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EPS Growth - Example

• One highly dubious reason for M&A is the case of "corporate raiders"
whose strategy relies not on synergy but "EPS growth".

Example: Acquirer (A) offers a 1 for 1 share swap to shareholders of Target

(T) - a premium of 33%.

A T A&T
Net Profit $20m $15m $35m
No. of shares 10m 5m 15m
EPS $2 $3 $2.33
P/E Ratio 20 10 20 (??)
Share Price $40 $30 $46.67
Market Value $400m $150m $700m??

EPS Growth – Example (cont)

General Rule:
• When the P/E paid by an Acquirer for a Target's EPS ($40/$3 = 13.33) is
less than acquirer’s P/E (20), the EPS of the combined entity will increase
• Example assumes that P/E of A&T will be 20 - but:
o Why does ‘T’ have a P/E of only 10 at present?
o What should the post-takeover P/E of A&T be?
o Can the “raider” keep fooling the market?

• If no growth from acquisition then total market value should be $550m

($400m + $150m) which implies a P/E ratio for A&T of 15.7 ($550m / EBIT
of $35m)

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Calculating Value

• Avoiding Mistakes
• Do not ignore market values
• Estimate only Incremental cash flows
• Use the correct discount rate
• Do not forget transactions costs

The NPV of a Merger

• Typically, a firm would use NPV analysis when making acquisitions.

• The analysis is straightforward with a cash offer, but it gets complicated
when the consideration is stock.

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The Cost of an Acquisition

• The net incremental gain from a merger is:
V = VAB – (VA + VB) → gross synergy
• and the total value of Firm B to Firm A (V*B)
V*B = VB + V
The NPV of the merger is therefore:
NPV = VB* – Cost to Firm A of the acquisition → net synergy

Cash Acquisition

• The NPV of a cash acquisition is:

NPV = (VB + ΔV) – cash paid = VB* – cash paid
• Value of the combined firm is:
VAB = VA + (VB* – cash paid)
• Often, the entire NPV goes to the target firm.
• Remember that a zero-NPV investment may also be desirable.

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Stock Acquisition

• Value of combined firm

VAB = VA + VB + DV
• Purchase price of acquisition
o Depends on the number of shares given to the target stockholders
o Depends on the price of the combined firm’s stock after the merger
• Considerations when choosing between cash and stock
o Sharing gains – target stockholders do not participate in stock price
appreciation with a cash acquisition
o Taxes – cash acquisitions are generally taxable
o Control – cash acquisitions do not dilute control

Cost of an Acquisition (cont)

Illustration
Firm A Firm B
Price per share $ 20 $ 15
Number of shares 600 400
Total market value $12,000 $6,000
• The incremental value of the acquisition (V) is estimated by Firm A to
be $2,800
• Firm B’s Board has indicated that it will agree to a sale at a price of
$7,600 payable in cash or shares
• The merger “premium” is $1,600 or ($7,600 – $6000)
• Should A acquire B? Should it pay cash or stock? → Need to
determine the NPV of the acquisition

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Cash Acquisition
• Remember, V*B = VB + V
= $6,000 + $2,800 = $8,800
• Therefore, the NPV of a cash acquisition is
o NPV = VB* – cash cost
o NPV = $8,800 - $7,600 = $1,200m
• Value of the combined firm (VAB) is
VAB = VA + (VB* - cash cost)
= $12,000 + ($8,800 - $7,600)
= $13,200
• The post-merger price per share will be:
$13,200 / 600 = $22 (a gain of $2 per share)

Cash Acquisition (cont)

• Firm A has paid an acquisition premium of 26.7% (7,600 – 6000) / $6,000

• Firm B’s shareholders receive $7,600 regardless of whether the synergies are
realised or not (that is, they do not share any risk or reward from the merger)
• The gain of $1,200 ($2,800 - $1,600) all accrues to firm A shareholders –
assuming synergistic gains are achieved.
• Equally, if the expected synergistic gains are not realised then Firm A
shareholders bear the risk

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Stock Acquisition

• In this case, the value of the combined firm

• VAB = VA + VB + DV
= $12,000 + $6,000 + $2,800 = $20,800
• Cost of acquisition
• Depends on number of shares given to target stockholders
• To give up $7,600 worth of shares at current price of $20 would require Firm A issuing 380
shares
• Post-merger the value $20,800 divided by 980 shares (600 + 380) is $21.2245
• Note: the share price is lower under this option because Firm B shareholders also own
stock in the new firm

Stock Acquisition (cont)

• In fact, the total value of the consideration received by B’s
shareholders is:
380 shares x $21.2245 = $8065.3
• The NPV (to A) = ($6,000 + $2,800) - $8065.3
= $734.7
• Check: [600($21.2245 - $20)] = $734.7
• With the stock acquisition Firm B’s shareholders get to share in the
benefits (or losses if the benefits are not realised) as they are now
shareholders in Firm A
• That is, Firm B’s shareholders may get a higher return this way but
they also share the risk.

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Stock Acquisition (cont.) - Cash or Stock?

• Considerations when choosing

o Inan overvalued (bubble) market better to pay with shares as all parties share
the burden of a stock price correction (especially so if you think your shares
are more overvalued than the target’s)
o Themore confident you are of the “value” to be created by the synergistic
benefits the more you will be inclined to pay with cash because target
stockholders don’t participate in stock price appreciation
o Taxes – cash acquisitions are generally taxable
o Capital structure – if paying with cash from a debt issue
o Control – cash acquisitions do not dilute control

The M&A Clasification

• Horizontal – both firms are in the same industry

• Vertical – firms are in different stages of the production process
• Conglomerate – firms are unrelated

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Friendly vs. Hostile Takeovers

• In a friendly merger, both companies’ management are receptive.

• In a hostile merger, the acquiring firm attempts to gain control of the target
without their approval.
• Tender offer
• Proxy fight

Defensive Tactics

• Corporate charter
• Classified board (i.e., staggered elections)
• Supermajority voting requirement

• Golden parachutes
• Targeted repurchase (a.k.a. greenmail)
• Standstill agreements
• Poison pills
• Leveraged buyouts

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Q&A

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