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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

November
July 2012 2012
U.S.
Airways AMR and Details of the
proposes U.S. Airways U.S. Airways proposes merger are
merger to AMR creditors begin merger, with its
encourage AMR worked out.
bankrupt merger shareholders owning
to merge with discussions. Merger filed
AMR. 30% of the new
another airline, with the FTC
company.
instead of under Hart-
emerging from September Scott-Rodino
April 2012 bankruptcy alone. Act.
2012

February
2013

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2. MERGERS AND ACQUISITIONS DEFINITIONS

Merger with Consolidation Acquisition

Company
Company
A
X

Company Company
C X

Company
Company
B
Y

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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 Companies are in the Walt Disney Company
merger same line of business, buys Lucasfilm (October
often competitors. 2012).
Vertical merger Companies are in the Google acquired Motorola
same line of production Mobility Holdings (June
(e.g., suppliercustomer). 2012).
Conglomerate Companies are in Berkshire Hathaway
merger unrelated lines of acquires Lubrizol (2011).
business.

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3. MOTIVES FOR MERGER
Synergy
Growth
Creating Value Increasing market power
Acquiring unique capabilities or resources
Unlocking hidden value

Exploiting market imperfections


Overcoming adverse government policy
Cross-Border
Technology transfer
Mergers
Product differentiation
Following clients
Diversification
Dubious Bootstrapping earnings
Motives 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 One Company Two Post-Acquisition
Earnings $100 million $50 million $150 million
Number of shares 100 million 50 million 125 million
Earnings per share $1 $1 $1.20
P/E 20 10 20
Price per share $20 $10 $24
Market value of stock $2,000 million $500 million $3,000 million

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EXAMPLE: BOOTSTRAPPING EARNINGS

$100 $50
Weighted PE = 20 + 10 = 16.67
$150 $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 One Company Two Post-Acquisition
Earnings $100 million $50 million $150 million
Number of shares 100 million 50 million 125 million
Earnings per share $1 $1 $1.20
P/E 20 10 16.67
Price per share $20 $10 $20
Market value of stock $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 Types of
Cycle Stage Description Motives for Merger Mergers
Pioneering Industry exhibits Younger, smaller companies may Conglomerate
development substantial sell themselves to larger companies Horizontal
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 Conglomerate
accelerating high profit margins require large capital requirements Horizontal
growth caused by few to expand existing capacity.
participants in the
market.

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MERGERS AND THE INDUSTRY LIFE CYCLE
Industry Life Industry Types of
Cycle Stage Description Motives for Merger Mergers
Mature Industry Mergers may be undertaken to Horizontal
growth experiences a achieve economies of scale, Vertical
drop in the entry savings, and operational
of new efficiencies.
competitors, but
growth potential
remains.
Stabilization Industry faces Mergers may be undertaken to Horizontal
and market increasing achieve economies of scale in
maturity competition and research, production, and
capacity marketing to match the low cost
constraints. 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 Types of
Cycle Stage Description Motives for Merger Mergers
Deceleration Industry faces Horizontal mergers may be Horizontal
of growth and overcapacity and undertaken to ensure survival. Vertical
decline eroding profit Vertical mergers may be carried out Conglomerate
margins. 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 Stock purchase


Transaction Asset purchase
Cash
Method of
Securities
Payment
Combination of cash and securities

Attitude of Hostile
Management 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 Merger Transactions, 2005
- Cash offering may be cash from
existing acquirer balances or from a
debt issue. Cash only
Securities offering
- Target shareholders receive shares Stock only
of common stock, preferred stock, or
debt of the acquirer.
Cash and
- The exchange ratio determines the securities
number of securities received in
exchange for a share of target stock. Other
securities
Factors influencing method of
payment:
- Sharing of risk among the acquirer
and target shareholders.
- Signaling by the acquiring firm.
- Capital structure of the acquiring Based on data from Mergerstat Review, 2006. FactSet
firm. Mergerstat, LLC (www.mergerstat.com).

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MINDSET OF MANAGERS
Friendly merger: Offer made through Hostile merger: Offer made directly
the targets board of directors to the target shareholders

Approach target management. Types

Bear hug
Tender offer
Enter into merger discussions.
Proxy fight

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 Post-Offer Takeover Defense
Mechanisms Mechanisms
Poison pills (flip-in pill and flip-over Just say no defense
pill) Litigation
Poison puts Greenmail
Incorporation in a state with Share repurchase
restrictive takeover laws
Leveraged recapitalization
Staggered board of directors
Crown jewels defenses
Restricted voting rights
Pac-Man defense
Supermajority voting provisions
White knight defense
Fair price amendments
White squire defense
Golden parachutes

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6. REGULATION

Antitrust Securities
Law Law

Regulation
of Mergers
and
Acquisitions

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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 HHI Market HHI
Company Share Before Company Share After
A 25% 625 A 25% 625
B 15% 225 B 15% 225
C 15% 225 C 15% 225
D 15% 225 D 15% 225
E 15% 225 E+F 30% 900
F 15% 225
Total 100% 1125 Total 100% 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 From the pro forma income statement
Net income $40 Change in deferred taxes $3
Interest expense $5 Depreciation $10
Interest income $2 Change in working capital $6
Capital expenditures $20
Assumed

Tax rate = 45%

What is ABCs free cash flow?

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EXAMPLE: FCF

Net income $40.00


Plus Net interest after tax 1.65
Equals Unlevered net income $41.65
Plus Change in deferred taxes 3.00
Equals Net operating profit minus adjusted taxes $44.65
Plus Depreciation 10.00
Minus Change in working capital 6.00
Minus Capital expenditures 20.00
Equals Free cash flow $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 Average of Comparables


Earnings $10 million P/E of comparables 30 times
Cash flow $12 million P/CF of comparables 25 times
Book value of equity $50 million P/BV of comparables 2 times
Sales $100 million P/S of comparables 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 Estimated
Multiples Stock Value
Earnings $10 million 30 $300 million
Cash flow $12 million 25 $300 million
Book value of equity $50 million 2 $100 million
Sales $100 million 2.5 $250 million
Average = $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 post-
merger

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COMPARABLE TRANSACTION ANALYSIS

Collect
Information on Calculate Estimate
Recent Takeover Multiples for Takeover Value
Transactions of Comparable Based on
Comparable Companies Multiples
Companies

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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
MNO Company Comparable Transactions
Earnings $10 million P/E of comparables 15 times
Cash flow $12 million P/CF of comparables 20 times
Book value of equity $50 million P/BV of comparables 5 times
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 Estimated
Multiples Stock Value
Earnings $10 million 15 $150 million
Cash flow $12 million 20 $240 million
Book value of equity $50 million 5 $250 million
Sales $100 million 3 $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 (10-7)
where
PT = price paid for the target company
VT = pre-merger value of the target company

Acquirers gain = Synergies Premium = S (PT VT) (10-8)


where
S = synergies created by the business combination

VA* = VA + VT + S C (10-9)
where
VA* = post-merger value of the combined companies
VA = pre-merger value of the acquirer
C = cash paid to target shareholders

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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 Spin-Off
Parent
compan
y

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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