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Mergers and Acquisitions

Merger activity in 2000-01
Acquiring Firm Selling Firm Payment ($ bn)
Vodafone Air Touch (UK) Mannesmann (Ger) 202.8
AOL Time Warner 106.0
Pfizer Warner-Lambert 89.2
Glaxo Wellcome (UK) SmithKline Beecham (US/UK) 76.0
Bell Atlantic GTE 53.4
Total Fina (Fr) Elf Aquitaine (Fr) 50.1
AT&T MediaOne 49.3
France Telecom (Fr) Orange (UK) 46.0
Viacom CBS 39.4
Chase Manhattan J.P. Morgan 33.6
Source: Mergers and Acquisitions
Types of transactions
• Mergers, acquisitions, takeovers and buyouts are types of
transactions that change the ownership of firms

• During the period 1980-2000, the distribution of such
transactions among US nonfinancial firms was as follows:

– There were 4,686 mergers, acquisitions and takeovers worth
$3,258 billion in aggregate market equity value

– There were 465 buyouts worth $60 billion

– There were 337 reverse buyouts worth $65 billion
• A merger is the complete absorption of one firm by another and
in this scenario we refer to an acquisition that takes place in
friendly terms

• The acquiring firm retains its identity and acquires all the assets
and liabilities of the acquired firm that ceases to exist and, thus,
such transactions are also called acquisitions (e.g. the
acquisition of McDonnell Douglas by Boeing)

• In a consolidation, both firms cease to exist and a new firm is
created after the acquisition (e.g. Peco Energy and Unicom
merged to form the new utility firm Exelon)
• In the typical merger, the stockholders of the ceased firm
receive either cash or shares in the surviving firm

• The acquiring firm makes an offer to the stockholders of the
acquired (or target) firm to purchase their shares through cash,
shares in the new firm or both

• Another form of an acquisition is for the acquiring firm to
purchase all the assets of the acquired firm, but this may be a
costly procedure

• Acquisitions can be
– Horizontal: a firm acquires another firm in the same industry
(Daimler – Chrysler in 1998)
– Vertical: a firm acquires another firm in a different stage (backward
or forward) of the production process (GM - Fisher Body)
– Conglomerate (merger): combination of two firms in unrelated
industries (Mobil Oil – Montgomery Ward in 1974)

• A takeover is the purchase of one firm by another firm

• If the takeover is friendly, then it is basically an acquisition, but if
not, then it is known as hostile takeover (IBM’s acquisition of
Lotus in 1995; Oracle’s bid for PeopleSoft in 2003)

Mechanics of M&As
Antitrust Law

– Proposed merger must pass scrutiny by the Department of Justice
and the Federal Trade Commission (FTC)

– Clayton Act (1914) forbids acquisitions that may substantially
lessen competition or tend to create a monopoly

• The government may forbid a merger, or require the parties to
divest some assets before the merger is completed in order to
lessen market power in a particular sector

M&A accounting

• From an accounting standpoint, a merger or acquisition can be
treated as a purchase of assets or a pooling of interests

• Under the pooling of interest approach

– Stock is exchanged between the two firms

– The balance sheet of the merged firm is nothing more than the two
separate balance sheets added together
• Under the purchase of assets method, the acquiring firm buys
the target firm using cash

• If the acquiring firm pays a premium over the target firm’s book
value (e.g. for intangible assets, such as a promising new
technology developed by the target), the difference is booked
against goodwill

• Goodwill has to amortized and these charges reduce reported
income, which most firms do not like and that is why the pooling
of interests method is typically preferred
Tax issues

• An acquisition may be taxable or tax-free

• In a taxable acquisition, the shareholders of the target firm pay
taxes on capital gains because they have sold their shares

• In a tax-free acquisition, the shareholders of the target firm who
have exchanged their shares are assumed to have no capital
gains or losses, as long as they continue to have a stake in the
new firm
Reasons for M&As

• Economies of scale from horizontal mergers (e.g. BP and
Amoco expected to save $2 bn annually from operations)

• Economies of scope from vertical mergers (integrate suppliers,
such as in the case of GM and Delphi, but recent trend is
towards outsourcing)

• Complementarities: a small firm may have a unique product, but
may need the experience in marketing and sales of a mature
firm that may also be in need of new products

• Unused tax shields: a firm may acquire another (loss-making)
firm to take advantage of tax-loss carry-forwards (IRS will object
if this is only reason for merger)

• Excess cash/inefficiencies
– A firm with excess cash can use it better by acquiring another firm
with good projects; a firm with excess cash can also become a
target of an acquisition if it is not investing the cash in positive NPV

– Acquisitions can also eliminate inefficiencies frequently related to
bad management
Other (not so good) reasons
for M&As

• The target firm tries to avoid bankruptcy and chooses to be
acquired (evidence shows these acquisitions not to be

• The Hubris Hypothesis: the acquiring firm’s management
overvalue their ability to create value once they take control of
the target firm’s assets

• Managers motivations to build an empire may lead to several
acquisitions that end up destroy value (e.g. WorldCom)
Gains from M&As
• M&As imply gains for the acquiring firm if there are synergies

• This implies that there should be incremental net gains so that
the value of the combined firm will be greater than the sum of
the two stand-alone firms

• The incremental net gains (synergies) are given by

V = V
– (V
+ V
• The net incremental gains are shown by estimating the
incremental cash flows from the acquisition, which are

FCF = EBIT + Depreciation - Tax - Capital

= Revenue - Cost - Tax - Capital

• Benefits of M&As arise from
–  Revenues (improved marketing, increased market power,
strategic gains from entering new industry)
–  Costs, taxes, cap. requirements (economies of scale and/or
scope, better use of resources of another firm, benefits of tax
shield, lower investment needs due to higher efficiency)
How much does an
acquisition cost?
• To determine the cost of an acquisition, we must calculate how
much a firm has to give up in order to acquire another firm

• The incremental net gain to firm 1 from acquiring firm 2 is given

V = V
– (V
+ V

• The value of firm 2 to firm 1 is

= V
+ V

• Therefore, firm 1 should proceed with the acquisition if the NPV
is positive

- C > 0

where C gives the cost to firm 1 of acquiring firm 2

• Firm 1 has two options: choose a cash acquisition or a stock
Case 1: Costs of a cash
• Suppose we have the following information about firms 1 and 2
and that firm 1 is considering acquiring firm 2

Firm 1 Firm 2
Price per share $20 $10
# of shares 25 10
Market value $500 $100
• Assume that
– Both firms are 100% equity owned
– The incremental net gain to firm 1 from acquiring firm 2 is $100
– Firm 2 has decided not to sell for less than $150 ($100 firm value + $50
acquisition premium)
• The value of firm 2 to firm 1 is
= V
+ V = $100 + $100 = $200
• The NPV of the cash acquisition is $200 - $150 = $50
• After the acquisition, firm 1’s value increases by $50 to $550 ($500 was
initial value) and firm 2’s stockholders have captured $50 out of the
$100 merger gains
• Firm 1 continues to have 25 share and each share will be worth
$550/25 = $22, meaning a gain of $2 per share
Case 2: Costs of a stock
• In a stock acquisition, the stockholders of firm 2 exchange their
shares for shares in the new firm

• The merged firm will be worth

= V
+ V
+ V = $500 + $100 + $100 = $700

• Since firm 2’s stockholders want to sell the firm for $150 they
will receive $150 worth of shares from firm 1 or $150/$20 = 7.5
shares given the price of firm 1’s shares
• The new firm has 25 + 7.5 = 32.5 shares worth $700 meaning a value
per share of $700/32.5 = $21.54, which is lower because firm 2’s
stockholders also own part of the new firm
• What was the cost of acquiring form 2 to firm 1? Was it only $150?
• The 7.5 shares of the merged firm owned by firm 2’s stockholders are
worth 7.5  $21.54 = $161.55
• The NPV of the stock acquisition is

- C = $200 - $161.55 = $38.45

which is lower than the NPV of the cash acquisition because firm 2’s
stockholders share some of the gains (but also the losses)

Implications of cash or stock acquisitions

• Using cash to finance an acquisition (merger) implies that the
cost is unaffected by the merger gains

• Using stock is preferred if there is potential for overvaluation or
undervaluation of either firm (e.g. if firm 1 overvalues firm 2 and
pays more, the bad news from discovering this fact in the future
will be shared by both firm 1’s and firm 2’s stockholders)
Market Reaction to Mergers
• Empirical evidence has shown that upon announcement of a
merger bid, on average:
– Share price of the targeted company rise 16%
– Share price of acquiring company are essentially unchanged (a fall
of 0.7%)
– Value of total package (buyer plus seller) rises on average by 1.8%

• Sellers earn higher returns because
– Buyers are typically substantially much larger firms that the
significant gains from the merger do not affect the firm’s share price
– More importantly, it is often the case that there is a competition
among bidders, which increases the gains for the target firm
• Most M&As are friendly and negotiated by the two firms’
managements and boards

• If a friendly acquisition is not possible and the acquiring firm
wants to take control of the target firm, the acquiring firm can

– Try to get the support of the target firm’s stockholders in the next
annual meeting (proxy fight)
– Go directly to the target firm’s stockholders and make them a
tender offer to sell their shares

Motives for takeovers
• Failure of target firm’s management may attract corporate

• Firms that have grown as a result of inefficient diversification
may become targets of a bust-up takeover where the firm’s
assets are divested so that it becomes more focused and

• Based on the hubris hypothesis, the target firm’s management
may resist the takeover because they do not accept the
argument that the acquiring firm’s management can run the firm
Takeover defenses
Pre-offer defenses

• Some firms adopt so-called shark-repellent charter amendments
to deter potential bidders

– Staggered boards (board is staggered in groups with only one
group elected each year, thus making it more difficult for bidders to
gain control)
– Require supermajority (above 80%) to approve a merger
– Restrict mergers unless a fair price is received
– Unwelcome acquirers must wait a number of years before a merger
can be completed
• Other pre-offer defenses include
– Poison pills: Existing shareholders are issued the right to buy stock
at a discount if there is a significant purchase of shares by an
outside bidder
– Poison put: Bondholders can demand repayment if there is a
hostile takeover

Post-offer defenses

• Issue new shares or repurchase shares from shareholders at a
• Buy assets that the bidder does not want or that can create
antitrust problems

• To eliminate resistance from management, the stockholders of
the target firm may offer their managers a golden parachute

• This is a generous payoff if the managers lose their job after the

• This benefits of the takeover will outweigh this cost for
stockholders in such a scenario