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CHAPTER 10 MERGERS AND ACQUISITIONS

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1. INTRODUCTION
Mergers and acquisitions (M&A) are complex, involving many parties. Mergers and acquisitions involve many issues, including - Corporate governance. - Form of payment. - Legal issues. - Contractual issues. - Regulatory approval. M&A analysis requires the application of valuation tools to evaluate the M&A decision.

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EXAMPLE OF A MERGER: AMR AND U.S. AIRWAYS

July 2012 U.S. Airways proposes merger to bankrupt AMR. April 2012 AMR and U.S. Airways begin merger discussions. September 2012

November 2012 U.S. Airways proposes merger, with its shareholders owning 30% of the new company. Details of the merger are worked out. Merger filed with the FTC under HartScott-Rodino Act. February 2013

AMR creditors encourage AMR to merge with another airline, instead of emerging from bankruptcy alone.

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2. MERGERS AND ACQUISITIONS DEFINITIONS


Merger with Consolidation
Acquisition

Company A

Company X

Company C
Company B
Company Y

Company X

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MERGERS AND ACQUISITIONS DEFINITIONS


Parties to the acquisitions: - The target company (or target) is the company being acquired. - The acquiring company (or acquirer) is the company acquiring the target. Classified based on endorsement of parties management: - A hostile takeover is when the target company board of directors objects to a takeover offer.

- A friendly transaction is when the target company board of directors endorses the merger or acquisition offer.

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MERGERS AND ACQUISITIONS DEFINITIONS


Classified by the relatedness of business activities of the parties to the combination: Type Characteristic Example

Horizontal merger
Vertical merger

Companies are in the same line of business, often competitors.


Companies are in the same line of production (e.g., suppliercustomer). Companies are in unrelated lines of business.

Walt Disney Company buys Lucasfilm (October 2012).


Google acquired Motorola Mobility Holdings (June 2012). Berkshire Hathaway acquires Lubrizol (2011).

Conglomerate merger

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3. MOTIVES FOR MERGER


Synergy Growth Increasing market power Acquiring unique capabilities or resources Unlocking hidden value Exploiting market imperfections Overcoming adverse government policy Technology transfer Product differentiation Following clients

Creating Value

Cross-Border Mergers

Dubious Motives

Diversification Bootstrapping earnings Managers personal incentives Tax considerations


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EXAMPLE: BOOTSTRAPPING EARNINGS


Bootstrapping earnings is the increase in earnings per share as a result of a merger, combined with the markets use of the pre-merger P/E to value post-merger EPS.
Assumptions: Exchange ratio: One share of Company One for two shares of Company Two Market applies pre-merger P/E of Company One to post-merger earnings. Company One Company Two Company One Post-Acquisition

Earnings Number of shares Earnings per share P/E Price per share Market value of stock
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$100 million 100 million $1 20 $20 $2,000 million

$50 million 50 million $1 10 $10 $500 million

$150 million 125 million $1.20 20 $24 $3,000 million


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EXAMPLE: BOOTSTRAPPING EARNINGS


Weighted P E = $100 20 + $150 $50 10 = 16.67 $150

Assumptions: Exchange ratio: One share of Company One for two shares of Company Two Market applies weighted average P/E to the post-merger company. Company One Company Two

Company One Post-Acquisition

Earnings Number of shares Earnings per share P/E Price per share

$100 million 100 million $1 20 $20

$50 million 50 million $1 10 $10

$150 million 125 million $1.20 16.67 $20

Market value of stock


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$2,000 million

$500 million

$2,500 million
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MOTIVES AND THE INDUSTRYS LIFE CYCLE


The motives for a merger are influenced, in part, by the industrys stage in its life cycle.

Factors include
- Need for capital. - Need for resources. - Degree of competition and the number of competitors.

- Growth opportunities (organic vs. external).


- Opportunities for synergy.

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MERGERS AND THE INDUSTRY LIFE CYCLE


Industry Life Industry Cycle Stage Description Motives for Merger Pioneering Industry exhibits Younger, smaller companies may development substantial sell themselves to larger companies development costs in mature or declining industries and has low, but and look for ways to enter into a slowly increasing, new growth industry. sales growth. Young companies may look to merge with companies that allow them to pool management and capital resources. Rapid Industry exhibits Explosive growth in sales may accelerating high profit margins require large capital requirements growth to expand existing capacity. caused by few participants in the market. Types of Mergers Conglomerate Horizontal

Conglomerate Horizontal

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MERGERS AND THE INDUSTRY LIFE CYCLE


Industry Life Industry Cycle Stage Description Mature Industry growth experiences a drop in the entry of new competitors, but growth potential remains. Stabilization Industry faces and market increasing maturity competition and capacity constraints. Motives for Merger Mergers may be undertaken to achieve economies of scale, savings, and operational efficiencies. Types of Mergers Horizontal Vertical

Horizontal Mergers may be undertaken to achieve economies of scale in research, production, and marketing to match the low cost and price performance of other companies (domestic and foreign). Large companies may acquire smaller companies to improve management and provide a broader financial base.
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MERGERS AND THE INDUSTRY LIFE CYCLE


Industry Life Industry Cycle Stage Description Deceleration Industry faces of growth and overcapacity and decline eroding profit margins. Types of Motives for Merger Mergers Horizontal mergers may be Horizontal undertaken to ensure survival. Vertical Vertical mergers may be carried out Conglomerate to increase efficiency and profit margins. Companies in related industries may merge to exploit synergy. Companies in this industry may acquire companies in young industries.

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4. TRANSACTION CHARACTERISTICS

Form of the Transaction Method of Payment Attitude of Management

Stock purchase Asset purchase

Cash Securities Combination of cash and securities


Hostile Friendly

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FORM OF AN ACQUISITION
In a stock purchase, the acquirer provides cash, stock, or combination of cash and stock in exchange for the stock of the target firm.

- A stock purchase needs shareholder approval.


- Target shareholders are taxed on any gain. - Acquirer assumes targets liabilities. In an asset purchase, the acquirer buys the assets of the target firm, paying the target firm directly. - An asset purchase may not need shareholder approval. - Acquirer likely avoids assumption of liabilities.

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METHOD OF PAYMENT
Cash offering - Cash offering may be cash from existing acquirer balances or from a debt issue. Securities offering - Target shareholders receive shares of common stock, preferred stock, or debt of the acquirer. - The exchange ratio determines the number of securities received in exchange for a share of target stock. Factors influencing method of payment: - Sharing of risk among the acquirer and target shareholders. - Signaling by the acquiring firm. - Capital structure of the acquiring firm.

Merger Transactions, 2005


Cash only Stock only

Cash and securities


Other securities

Based on data from Mergerstat Review, 2006. FactSet Mergerstat, LLC (www.mergerstat.com).

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MINDSET OF MANAGERS
Friendly merger: Offer made through the targets board of directors
Approach target management.

Hostile merger: Offer made directly to the target shareholders


Types Bear hug Tender offer Proxy fight

Enter into merger discussions.

Perform due diligence.

Enter into a definitive merger agreement.

Shareholders and regulators approve.

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HOSTILE VS. FRIENDLY MERGERS


The classification of a merger as friendly or hostile is from the perspective of the board of directors of the target company.

A friendly merger is one in which the board negotiates and accepts an offer.
A hostile merger is one in which the board of the target firm attempts to prevent the merger offer from being successful.

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5. TAKEOVERS
Takeover defenses are intended to either prevent the transaction from taking place or to increase the offer.

- Pre-offer mechanisms are triggered by changes in control, generally making the target less attractive.
- Post-offer mechanisms tend to address ownership of shares and reduce the hostile acquirers power gained from its ownership interest in the target.

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TAKEOVER DEFENSES
Pre-Offer Takeover Defense Mechanisms Post-Offer Takeover Defense Mechanisms

Poison pills (flip-in pill and flip-over pill)


Poison puts Incorporation in a state with restrictive takeover laws Staggered board of directors Restricted voting rights Supermajority voting provisions Fair price amendments Golden parachutes

Just say no defense


Litigation Greenmail Share repurchase

Leveraged recapitalization
Crown jewels defenses Pac-Man defense White knight defense White squire defense

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6. REGULATION

Antitrust Law
Regulation of Mergers and Acquisitions

Securities Law

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ANTITRUST LAW: UNITED STATES


Sherman Antitrust Act (1890) Made combinations, contracts, and conspiracies in restraint of trade or attempts to monopolize illegal Clayton Antitrust Act (1914) Outlawed specific business practices CellerKefauver Act (1950)

Closed loopholes in the Clayton Act


HartScottRodino Antitrust Improvements Act (1976)

Gave the FTC and the Justice Department an opportunity to review and challenge mergers in advance

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ANTITRUST
The European Commission reviews combinations for antitrust issues. Regulatory bodies besides the FTC may review combinations (e.g., U.S. Federal Communications Commission, Federal Reserve Bank, state insurance commissions). If the combination involves companies in different countries, it may require approvals by all countries regulatory bodies.

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THE HHI
The HerfindalhlHirschman Index (HHI) is a measure of concentration within an industry and is often used by regulators to evaluate the effects of a merger.

The HHI is constructed as the sum of the squared market shares of the firms in the industry: n 2 Output of firm i HHI = 100 Total sales or output of the market i

HHI Concentration Level and Possible Government Action Post-Merger HHI Concentration Change in HHI Government Action Less than 1,000 Not concentrated Any amount No action Between 1,000 and 1,800 Moderately concentrated 100 or more Possible challenge More than 1,800 Highly concentrated 50 or more Challenge

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EXAMPLE: HHI
Consider an industry that has six companies. Their respective market shares are as follows: Company Market Share A 25% B 15% C 15% D 15% E 15% F 15% 100%

What is the likely government action, if any, if Companies E and F combined?

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EXAMPLE: HHI
Market Company Share A B C 25% 15% 15% HHI Before 625 225 225 Market Company Share A B C 25% 15% 15% HHI After 625 225 225

D
E F Total

15%
15% 15% 100%

225
225 225 1125

D
E+F Total

15%
30% 100%

225
900 1575

The industry would be considered moderately concentrated before and after the combination of E and F, and The change in the HHI is 450, which may result in a government challenge.

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SECURITIES LAWS: UNITED STATES


Williams Act (1968): - Requires public disclosure when a party acquires 5% or more of a targets common stock. - Specifies rules and restrictions pertaining to a tender offer.

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7. MERGER ANALYSIS
The discounted cash flow (DCF) method is often used in the valuation of the target company.

The cash flow that is most appropriate is the free cash flow (FCF), which is the cash flow after capital expenditures necessary to maintain the company as an ongoing concern.
The goal is to estimate future FCF. - We can use pro forma financial statements to estimate FCF - We use a two-stage model when we can more accurately estimate growth in the near future and then assume a somewhat slower growth out into the future.

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ESTIMATING FREE CASH FLOW (FCF)


Calculate Net Interest after Tax (Interest expense Interest income) (1 Tax rate)

Calculate Unlevered Net Income Net income + Net interest after tax

Calculate NOPLAT Unlevered net income + Change in deferred taxes

Calculate FCF NOPLAT + Noncash charges Change in working capital Capital expenditures

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EXAMPLE: FCF FOR THE ABC COMPANY


Suppose analysts have constructed pro forma financial statements for the ABC Company and report the following:
From the pro forma income statement Net income Interest expense Interest income Assumed Tax rate = 45% What is ABCs free cash flow? $40 $5 $2 From the pro forma income statement Change in deferred taxes Depreciation Change in working capital Capital expenditures $3 $10 $6 $20

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EXAMPLE: FCF
Net income
Plus Equals Plus Equals Plus Minus Minus Equals Net interest after tax Unlevered net income Change in deferred taxes Net operating profit minus adjusted taxes Depreciation Change in working capital Capital expenditures Free cash flow

$40.00
1.65 $41.65 3.00 $44.65 10.00 6.00 20.00 $28.65

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DISCOUNTED CASH FLOW (DCF) AND THE TERMINAL VALUE


We can estimate the terminal value: - Assuming a constant growth after the initial few years or - Assuming a multiple (based on comparables) of pro forma FCF for the last estimated year.

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THE DCF METHOD


Advantages of using the DCF method: - The model allows for changes in cash flows in the future. - The cash flows and estimated value are based on forecasted fundamentals. - The model can be adapted for different situations. Disadvantages of using the DCF method: - For a rapidly growing company, the FCF and net income may be misaligned (e.g., higher-than-normal capital expenditure). - Estimating future cash flows is difficult because of the uncertainty. - Estimating discount rates is difficult, and these rates may change over time. - The terminal value estimate is sensitive to the assumptions and model used.

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COMPARABLE COMPANY ANALYSIS


Select Comparable Companies
Publicly traded companies that are similar to the subject company Same or similar industry

Calculate Relative Value Measures


Enterprise value multiples Price multiples

Apply Metrics to Target


Judgment needed to select appropriate metric

Estimate Takeover Price


Takeover premium added

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EXAMPLE: COMPARABLE COMPANY ANALYSIS


Suppose an analyst has gathered the following information on the target company, the XYZ Company:

XYZ Company
Earnings Cash flow Book value of equity Sales $10 million $12 million $50 million $100 million

Average of Comparables
P/E of comparables P/CF of comparables P/BV of comparables P/S of comparables 30 times 25 times 2 times 2.5 times

If the typical takeover premium is 20%, what is the XYZ Companys value in a merger using the comparable company approach?

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EXAMPLE: COMPARABLE COMPANY ANALYSIS


Assuming that the average of the values from the different multiples is most appropriate:

Comparables Multiples
Earnings Cash flow Book value of equity Sales $10 million $12 million $50 million $100 million 30 25 2 2.5 Average =

Estimated Stock Value


$300 million $300 million $100 million $250 million $237.5 million

Estimated takeover price of the XYZ Company = $237.5 million 1.2 = $285 million

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COMPARABLE COMPANY ANALYSIS


Advantages - Provides reasonable estimate of the target companys value - Readily available inputs - Estimates based on markets value of company attributes Disadvantages - Sensitive to market mispricing - Sensitive to estimate of the takeover premium, and historical premiums may not be accurate to apply to subsequent mergers - Does not consider specific changes that may be made in the target postmerger

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COMPARABLE TRANSACTION ANALYSIS

Collect Information on Recent Takeover Transactions of Comparable Companies

Calculate Multiples for Comparable Companies

Estimate Takeover Value Based on Multiples

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EXAMPLE: COMPARABLE TRANSACTION ANALYSIS


Suppose an analyst has gathered the following information on the target company, the MNO Company: Average of Multiples of Comparable Transactions P/E of comparables P/CF of comparables P/BV of comparables 15 times 20 times 5 times

MNO Company
Earnings Cash flow Book value of equity $10 million $12 million $50 million

Sales

$100 million

P/S of comparables

3 times

Estimate the value of the MNO Company using the comparable transaction analysis, giving the cash flow multiple 70% and the other methods 10% each.

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EXAMPLE: COMPARABLE TRANSACTION ANALYSIS


Comparables Transaction Multiples Estimated Stock Value

Earnings
Cash flow Book value of equity Sales

$10 million
$12 million $50 million $100 million

15
20 5 3

$150 million
$240 million $250 million $300 million

Value of MNO = 0.7 $240 + 0.1 $150 + 0.1 $250 + 0.1 $300 Value = $238 million

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COMPARABLE TRANSACTION ANALYSIS


Advantages - Does not require specific estimation of a takeover premium - Based on recent market transactions, so information is current and observed - Reduces litigation risk Disadvantages - Depends on takeover transactions being correct valuations - There may not be sufficient transactions to observe the valuations - Does not include value of changes to be made in target

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EVALUATING BIDS
The acquiring firm shareholders want to minimize the amount paid to target shareholders, not paying more than the pre-merger value of the target plus the value of the synergies.

The target shareholders want to maximize the gain, accepting nothing below the pre-merger market value.

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EVALUATING BIDS: FORMULAS


Target shareholders gain = Premium = PT VT
where PT = price paid for the target company VT = pre-merger value of the target company (10-7)

Acquirers gain = Synergies Premium = S (PT VT)


where S = synergies created by the business combination

(10-8)

VA* = VA + VT + S C
where VA* = post-merger value of the combined companies VA = pre-merger value of the acquirer C = cash paid to target shareholders

(10-9)

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EXAMPLE: EVALUATING BIDS


Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid was made public was $15 per share. Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%.

1. What are the synergistic gains from this merger?


2. What parties, if any, share in these gains? 3. What is the estimated value of the Big Company post-merger?

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EXAMPLE: EVALUATING BIDS


1. Synergistic gains = $2 million 0.10 = $20 million 2. Division of gains: First calculate the gains for each party and then evaluate the division. Target shareholders gain = $18 million $15 million = $3 million Acquirers gain = $20 million 3 million = $17 million Little shareholders get $3 million $20 million = 15% of the gain

Big shareholders get $17 million $20 million = 85% of the gain
3. Value of Big Company post-merger = $400 million + $15 million + $20 million $18 million = $417 million

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EFFECTS OF PRICE AND PAYMENT METHOD


The more confidence in the realization of synergies, - the greater the chance that the acquiring firm will pay cash and - the more the target company shareholders will prefer stock. The greater the use of stock in a deal, - the greater the burden of the risks borne by the target shareholders and - the greater the potential benefits accrue to the target shareholders. The greater the confidence of the acquiring firm managers in estimating the value of the target, the more likely the acquiring firm is to offer cash.

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8. WHO BENEFITS FROM MERGERS?


Mergers create value for the target company shareholders in the short run. Acquirers tend to overpay in merger bids. - The transfer of wealth is from acquirer to target company shareholders. - Roll: Overpayment results from hubris. Acquirers tend to underperform in the long run. - They are unable to fully capture any synergies or other benefit from the merger.

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MERGERS THAT CREATE VALUE


Buyer is strong. Transaction premiums are relatively low. Number of bidders is low. Initial market reaction to the news is favorable.

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9. CORPORATE RESTRUCTURING
A divestiture is the sale, liquidation, or spin-off of a division or subsidiary.

Equity Carve-Out

Liquidation Parent compan y

Spin-Off

Divestiture

Split-Off

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REASONS FOR RESTRUCTURING


Companies generally increase in size with a merger or acquisition. Restructuring, which includes divestitures, generally follows periods of merger and acquisitions. Reasons for restructuring: - Change in strategic focus - Poor fit

- Reverse synergy
- Financial or cash flow needs

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FORMS OF DIVESTITURE

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10. SUMMARY
An acquisition is the purchase of some portion of one company by another, whereas a merger represents the absorption of one company by another.

Mergers may be a statutory merger, a subsidiary merger, or a consolidation.


Horizontal mergers occur among peer companies engaged in the same kind of business, vertical mergers occur among companies along a given value chain, and conglomerates are formed by companies in unrelated businesses. Merger activity has historically occurred in waves. - Waves have typically coincided with a strong economy and buoyant stock market activity. - Merger activity tends to be concentrated in a few industries, usually those undergoing changes.

There are number of motives for a merger or acquisition; some are justified, some are dubious.

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SUMMARY (CONTINUED)
A merger transaction may take the form of a stock purchase or an asset purchase.

- The decision of which approach to take will affect other aspects of the transaction.
The method of payment for a merger may be cash, securities, or a mixed offering with some of both. Hostile transactions are those opposed by target managers, whereas friendly transactions are endorsed by the target companys managers. There are a variety of both pre- and post-offer defenses a target can use to ward off an unwanted takeover bid.

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SUMMARY (CONTINUED)
Pre-offer defense mechanisms include poison pills and puts, incorporation in a jurisdiction with restrictive takeover laws, staggered boards of directors, restricted voting rights, supermajority voting provisions, fair price amendments, and golden parachutes. Post-offer defenses include just say no defense, litigation, greenmail, share repurchases, leveraged recapitalization, crown jewel defense, Pac-Man defense, or finding a white knight or a white squire.

Antitrust legislation prohibits mergers and acquisitions that impede competition.


The Federal Trade Commission and Department of Justice review mergers for antitrust concerns in the United States. The European Commission reviews transactions in the European Union. The HerfindahlHirschman Index (HHI) is a measure of market power based on the sum of the squared market shares for each company in an industry. The Williams Act is the cornerstone of securities legislation for M&A activities in the United States.
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SUMMARY (CONTINUED)
Three major tools for valuing a target company are discounted cash flow analysis, comparable company analysis, and comparable transaction analysis.

In a merger bid, the gain to target shareholders is the takeover premium. The acquirer gain is the value of any synergies created by the merger, minus the premium paid to target shareholders.
The empirical evidence suggests that merger transactions create value for target company shareholders, yet acquirers tend to accrue value in the years following a merger. A divestiture is a transaction in which a company sells, liquidates, or spins off a division or a subsidiary. A company may divest assets using a sale to another company, a spin-off to shareholders, or a liquidation.

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