Mergers and acquisitions (M&A) and corporate restructuring are a big part of the corporate finance world.
Every day, Wall Street investment bankers arrange M&A transactions, which bring separate companies
together to form larger ones. When they're not creating big companies from smaller ones, corporate
finance deals do the reverse and break up companies through spinoffs, carve-outs or tracking stocks.

Not surprisingly, these actions often make the news. Deals can be worth hundreds of millions, or even
billions, of dollars. They can dictate the fortunes of the companies involved for years to come. For a CEO,
leading an M&A can represent the highlight of a whole career. And it is no wonder we hear about so
many of these transactions; they happen all the time. Next time you flip open the newspaper's business
section, odds are good that at least one headline will announce some kind of M&A transaction.

Sure, M&A deals grab headlines, but what does this all mean to investors? To answer this question, this
tutorial discusses the forces that drive companies to buy or merge with others, or to split-off or sell parts
of their own businesses. Once you know the different ways in which these deals are executed, you'll have
a better idea of whether you should cheer or weep when a company you own buys another company -
or is bought by one. You will also be aware of the tax consequences for companies and for investors.

Mergers and Acquisitions: Definition

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%e Main Idea
One plus one makes three: this equation is the special alchemy of a merger or an acquisition. The key principle
behind buying a company is to create shareholder value over and above that of the sum of the two companies. Two
companies together are more valuable than two separate companies - at least, that's the reasoning behind M&A.

This rationale is particularly alluring to companies when times are tough. Strong companies will act to buy other
companies to create a more competitive, cost-efficient company. The companies will come together hoping to gain a
greater market share or to achieve greater efficiency. Because of these potential benefits, target companies will often
agree to be purchased when they know they cannot survive alone.

Distinction between Mergers and Acquisitions
Although they are often uttered in the same breath and used as though they were synonymous, the terms merger and
acquisition mean slightly different things.

When one company takes over another and clearly established itself as the new owner, the purchase is called an
acquisition. From a legal point of view, the target company ceases to exist, the buyer "swallows" the business and the
buyer's stock continues to be traded.

Ìn the pure sense of the term, a merger happens when two firms, often of about the same size, agree to go forward
as a single new company rather than remain separately owned and operated. This kind of action is more precisely
referred to as a "merger of equals." Both companies' stocks are surrendered and new company stock is issued in its
place. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new
company, DaimlerChrysler, was created.

Ìn practice, however, actual mergers of equals don't happen very often. Usually, one company will buy another and,
as part of the deal's terms, simply allow the acquired firm to proclaim that the action is a merger of equals, even if it's
technically an acquisition. Being bought out often carries negative connotations, therefore, by describing the deal as a
merger, deal makers and top managers try to make the takeover more palatable.

A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of
both of their companies. But when the deal is unfriendly - that is, when the target company does not want to be
purchased - it is always regarded as an acquisition.

Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or
hostile and how it is announced. Ìn other words, the real difference lies in how the purchase is communicated to and
received by the target company's board of directors, employees and shareholders.

Synergy is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of
revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:

O Staff reductions - As every employee knows, mergers tend to mean job losses. Consider all the money
saved from reducing the number of staff members from accounting, marketing and other departments. Job
cuts will also include the former CEO, who typically leaves with a compensation package.
O Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new corporate ÌT system, a
bigger company placing the orders can save more on costs. Mergers also translate into improved
purchasing power to buy equipment or office supplies - when placing larger orders, companies have a
greater ability to negotiate prices with their suppliers.
O Acquiring new technology - To stay competitive, companies need to stay on top of technological
developments and their business applications. By buying a smaller company with unique technologies, a
large company can maintain or develop a competitive edge.
O Ìmproved market reach and industry visibility - Companies buy companies to reach new markets and grow
revenues and earnings. A merge may expand two companies' marketing and distribution, giving them new
sales opportunities. A merger can also improve a company's standing in the investment community: bigger
firms often have an easier time raising capital than smaller ones.

That said, achieving synergy is easier said than done - it is not automatically realized once two companies merge.
Sure, there ought to be economies of scale when two businesses are combined, but sometimes a merger does just
the opposite. Ìn many cases, one and one add up to less than two.

Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal makers. Where there
is no value to be created, the CEO and investment bankers - who have much to gain from a successful M&A deal -
will try to create an image of enhanced value. The market, however, eventually sees through this and penalizes the
company by assigning it a discounted share price. We'll talk more about why M&A may fail in a later section of this

'arieties of Mergers
From the perspective of business structures, there is a whole host of different mergers. Here are a few types,
distinguished by the relationship between the two companies that are merging:

O Horizontal merger - Two companies that are in direct competition and share the same product lines and
O Vertical merger - A customer and company or a supplier and company. Think of a cone supplier merging
with an ice cream maker.
O Market-extension merger - Two companies that sell the same products in different markets.
O Product-extension merger - Two companies selling different but related products in the same market.
O Conglomeration - Two companies that have no common business areas.

There are two types of mergers that are distinguished by how the merger is financed. Each has certain
implications for the companies involved and for investors:

O Purchase Mergers - As the name suggests, this kind of merger occurs when one company
purchases another. The purchase is made with cash or through the issue of some kind of debt
instrument; the sale is taxable.

Acquiring companies often prefer this type of merger because it can provide them with a tax
benefit. Acquired assets can be written-up to the actual purchase price, and the difference between
the book value and the purchase price of the assets can depreciate annually, reducing taxes
payable by the acquiring company. We will discuss this further in part four of this tutorial.
O Consolidation Mergers - With this merger, a brand new company is formed and both companies are
bought and combined under the new entity. The tax terms are the same as those of a purchase

As you can see, an acquisition may be only slightly different from a merger. Ìn fact, it may be different in name only.
Like mergers, acquisitions are actions through which companies seek economies of scale, efficiencies and enhanced
market visibility. Unlike all mergers, all acquisitions involve one firm purchasing another - there is no exchange of
stock or consolidation as a new company. Acquisitions are often congenial, and all parties feel satisfied with the deal.
Other times, acquisitions are more hostile.

Ìn an acquisition, as in some of the merger deals we discuss above, a company can buy another company with cash,
stock or a combination of the two. Another possibility, which is common in smaller deals, is for one company to
acquire all the assets of another company. Company X buys all of Company Y's assets for cash, which means that
Company Y will have only cash (and debt, if they had debt before). Of course, Company Y becomes merely a shell
and will eventually liquidate or enter another area of business.

Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly-listed in a
relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager
to raise financing buys a publicly-listed shell company, usually one with no business and limited assets. The private
company reverse merges into the public company, and together they become an entirely new public corporation with
tradable shares.

Regardless of their category or structure, all mergers and acquisitions have one common goal: they are all meant to
create synergy that makes the value of the combined companies greater than the sum of the two parts. The success
of a merger or acquisition depends on whether this synergy is achieved

One size doesn't fit all. Many companies find that the best way to get ahead is to expand ownership
boundaries through mergers and acquisitions. For others, separating the public ownership of a subsidiary
or business segment offers more advantages. At least in theory, mergers create synergies and
economies of scale, expanding operations and cutting costs. Ìnvestors can take comfort in the idea that a
merger will deliver enhanced market power.

By contrast, de-merged companies often enjoy improved operating performance thanks to redesigned
management incentives. Additional capital can fund growth organically or through acquisition. Meanwhile,
investors benefit from the improved information flow from de-merged companies.

M&A comes in all shapes and sizes, and investors need to consider the complex issues involved in M&A.
The most beneficial form of equity structure involves a complete analysis of the costs and benefits
associated with the deals.

Let's recap what we learned in this tutorial:

O A merger can happen when two companies decide to combine into one entity or when one
company buys another. An acquisition always involves the purchase of one company by another.
O The functions of synergy allow for the enhanced cost efficiency of a new entity made from two
smaller ones - synergy is the logic behind mergers and acquisitions.
O Acquiring companies use various methods to value their targets. Some of these methods are
based on comparative ratios - such as the P/E and P/S ratios - replacement cost or discounted
cash flow analysis.
O An M&A deal can be executed by means of a cash transaction, stock-for-stock transaction or a
combination of both. A transaction struck with stock is not taxable.
O Break up or de-merger strategies can provide companies with opportunities to raise additional
equity funds, unlock hidden shareholder value and sharpen management focus. De-mergers can
occur by means of divestitures, carve-outs spinoffs or tracking stocks.
O Mergers can fail for many reasons including a lack of management foresight, the inability to
overcome practical challenges and loss of revenue momentum from a neglect of day-to-day

Developing a capital structure

Capital structure theory emphasize on the balance between debt and equity. Due to tax
debt is considered a cheaper method of capitalization than equity however if a company
leverages excessively it increases risks of financial distress.
Companies use a more practical approach in designing a capital mix by considering at the
cost of capital, alignment of capital structure with strategy, flexibility to respond to rapidly
changing market conditions and focus on liquidity to minimize reliance on external
Leading companies manage capital structure effectively to take advantage of opportunities,
manage risk and meet the changing needs of the business. The following are some of the
best practices used by companies in designing capital structure:
1. Select the instruments that effectively meets company' s funding requirements
There is no one single source or a combination of sources of capital is appropriate for a
company. Leading companies evaluate available funding options, pros and cons of debt and
equity and cost of capital in order to understand the financial, regulatory and operational
risks they are likely to face.
Each company will take the options that best fit it with the confidence that it has flexibility
to handle a drastic change in the business.
. Align capital structure with company strategy
Best practice companies develop a capital mix that supports the company strategy leaving
room for flexibility to be able to respond to changing business environment.
By determining an appropriate credit risk threshold and putting in place a disciplined private
equity management tactics, effective companies create a capital structure that supports
organizational objectives and operational excellence.
3. Establish the company's cost of capital
Leading companies keep awareness of their cost of capital to accurately determine threshold
of capital investment. The most popular method to compute cost of capital is getting a
company´s weighted average cost of capital (WACC).
WACC formula is straight forward but can be complicated by fluctuating input that
determines its outcome. Leading companies regularly keep measuring its cost of capital to
keep a close tab where its losing or gaining value.
The companies that use various different methods of computing WACC get a more
comprehensive understanding of their position and enable them to make better strategic
decisions to deal with the industry and its competitors.
4. Make effort to reduce cost of capital on an ongoing basis
Leading companies strive to make efforts to reduce cost of capital. While ways of reducing
cost of capital may not be specific their cumulative effects may help a company reduce cost
of capital through strategy as opposed to just cutting capital cost.
Best practice companies exercise financial transparency to attract investors who offer their
capital at lower cost than competitors.
They keep good relationship with banks to enjoy favorable lending rates which in turn has a
positive impact on the profitability.
5. Manage flexible capital actively
Best practice companies are proactive in balancing debt to equity ratio to be able to respond
to internal and external factors that affect cost of capital. Flexible financial policies that
affect dividends where lower amounts can be paid as dividend and the rest retained to grow
the business are useful to many companies.
6. Keep exploring new finance sources continuously
Best practice companies move from reliance on traditional sources of capital like commercial
banks, public debt, equity markets or institutional investors to avoid being victims of the
changes in the market by continuously searching for alternative non traditional sources of
capital on a continuous basis.
They partner with other business, use assets as collateral and creating corporate structures
to insulate the parent company from excessive risks.
apital structure is about balancing debt and equity, however too
much debt may increase unseen risks.


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