Mergers and Acquisitions

Mergers and Acquisitions
The Value of Corporate

Level Stategy
M&A Alliances Spin-Offs
Value >=< Value >=< Value
A B
A B
A B
>=< >=<
A
A B
B
The Value of Corporate Strategy
1. Which businesses to enter or
exit? Issue: diversification,
M&A, joint ventures, strategic
alliance, divestment, spin offs.
Creation
of
Value?
2. How to allocate 3. Coordination

resources across and control of
business units. business units.
Creation of Value?
Loss of Value to Shareholder of Acquirer
around Announcement Date
the median excess return over the five-day window around the
announcement was -0.6%.
Hazelkorn, T., Zenner, M. And Shivdasani, A. 2004. Creating Value with Mergers and Acquisitions.
Journal of Applied Corporate Finance. Vol 16: 2-3
Creation of Value?
Wide Variation in Value Loss and
Gain
Beliefs about diversification:
By acquiring businesses unrelated to its core business, a firm will
lessen the firm-specific variability of its cash flows.
Advantages of diversification:
Market power advantages
Internal market efficiencies
Superior access to information
Use of firm specific assets
Sensible Reasons for Mergers
Economies of Scale
A larger firm may be able to reduce its per
unit cost by using excess capacity or
spreading fixed costs across more units.
Reduces costs
$ $ $
Economies of Vertical Integration
Control over suppliers “may” reduce costs.
Over integration can cause the opposite effect.
Pre-integration Post-integration
(less efficient) (more efficient)
Company Company
S
S S
S S
S S S
Combining Complementary Resources
Merging may results in each firm filling in the “missing
pieces” of their firm with pieces from the other firm.
Firm A
Firm B
Mergers as a Use for Surplus Funds

If your firm is in a mature industry with
few, if any, positive NPV projects available,
acquisition may be the best use of your
funds.
Dubious Reasons for Mergers
Diversification
Investors should not pay a premium for
diversification since they can do it themselves.
Free cash flow problem - agency effects
Problem of coordination
Hubris – tendency to overpay for targets

(by up to 30%)
Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to low

number of shares)
After merger, acquiring firm has short

term EPS rise
Long term, acquirer will have slower than

normal EPS growth due to share dilution.
Table 21.2
Impact of merger on market value and
earning per share of World Enterprises
P/E ratio 20 10 15
Buying a firm with a lower P/E ratio can increase earnings per share. But
the increase should not result in a higher share price. The short-term
increase in earnings should be offset by a lower future earnings growth.
Estimating Merger Gains
• Questions
– Is there an overall economic gain to the
merger?
– Do the terms of the merger make the company
and its shareholders better off?
PV(AB) > PV(A) + PV(B) ???

Gain = PVAB – (PVA + PVB) = Δ PVAB
Cost = Cash Paid – PVB
NPV = gain – cost

Table 21.3
Cislunar Foods is considering an acquisition of Targetco.
The merger would increase the companies’ combined earnings
by $4million.
Table 21.3
Economic Gain = PV (increased earnings) =

4 = $20 million
.20
Cost of capital = 20%
Table 21.3
Merger Funded by Cash
Terms of merger:
Consider cash offer $19 per share ($3 above current price)
2.5 million shares x 19 = $47.5
Cost = cash paid out – Targetco value = $47.5 – $40 = $7.5
NPV = economic gain – cost = $20 = $7.5 = $12.5
Table 21.3
Post Merger Market Value:

Cislunar market value prior to merger $480 million
Targetco market value 40
Present Value of gain to merger 20
Less cash paid out to Targetco shareholders -47.5
Post-merger market value $492.5
Post merger share price = $492.5 / 100,000 = $49.25

Increase in value per share $49.25 - $48 = $1.25
Total Increase in value for Cislunar = 1.25 x 100,000 = 12.5 million
Gain = PVAB – (PVA + PVB) = Δ PVAB
NPV = gain – cost

PVA = €480
PVB = €40
Gain = Δ PVAB = + €20

= €47.5 - €40 = €7.5
NPV = gain – cost

= €20 - €7.5 = €12.5
Mergers Financed by Stock
Table 21.4
Financial forecasts after the Cislunar-Targetco Merger.
The left hand column assumes a cash purchase of $19 per
Targetco share. The right hand column assumes Targetco
shareholders receive ONE new Cislunar share for every THREE
Targetco share.
Mergers Financed by Stock
Table 21.4
*
*$540 = $492.5 + $47.5 (retained cash)
No. of share = 10,000,000 + (2,500,000/3) = 10,833,333
Price per share = 540/10.833 = $49.85
Value of shares issued = 833,333 x $49.85 = $41.5
Cost = value of shares issued – Target co Value

= 41.5 m - $40 m = $1.5m
NPV = economic gain – cost
= 20m -1.5m = $18.5m
Value: Which Factors Matter?
Financing Structure.
Cash-financed acquirors outperformed industry peers
by 4.3% while stock-financed acquirors underperformed
industry peers by 5.2%.
Cash acquisition can send a positive signal to
investors about the acquiror‘s confidence in its ability to
replenish its cash balance.
Cash-financed transactions often involve
significant debt issuance and the resulting pressure
to repay this debt can provide a significant
incentive to realize synergies and to closely manage
the merger integration process.
Financing Structure.
Equity financed transaction can signal to the market

that the acquiror believes its stock to be overpriced,
and the increased supply of the security can put
downward price pressure on the stock in the short
term.
In addition, takeover arbitrageurs tend to buy the

target company stock and sell the acquiror's stock.
At least in the short term, this may put downward
pressure on the stock.
How should firms finance growth?
Related versus Unrelated diversification;
Acquisition or Greenfield
unrelated
related
equity
debt
4th Dimension
Acquisition
public private or Greenfield
Some Observations
Equity financing is preferred for related diversification
and unrelated diversification is associated with debt financing.
Firms diversifying through acquisitions are more likely to use

public sources of financing and
those emphasizing internal development of new businesses depend

primarily on private sources of financing.
Target Company Status
(Public versus Private;
Whole Company versus Asset or Business Unit).
When the target was a private company or an asset or
business unit of a public company, transactions were
associated with median short-term acquiror excess
returns of 1.9% and median long-term excess returns of
4.2%.
In contrast, transactions in which the target was a

publicly traded company led to short-term returns of-
2.3% around the acquisition and an industry-adjusted
-4.4% for the following two years.
Focused versus Diversifying Acquisitions
The short-term reaction to both types of transactions is similar
(median excess returns for both groups equaled -0.6%). In the long
term, however, acquirors in focused transactions outperfonned their
industry counterparts by approximately 2% while acquirors in
diversifying transactions underperformed their industries by almost
-3%
Focused transactions may be more successful than diversifying

transactions because it is easier to realize synergies
Cultural and social issues are often accentuated in

cross-industry transactions, which points to the importance
of post-merger integration and execution in determining an
acquisition's success.
Target Company Status
Why?
Acquisitions of whole public companies tend to
be broader in scope, and thus more prone to
complex integration problems.
Acquisitions of public companies typically occur

at a premium to an already-established public
price.
Acquisitions of business units or private

companies are typically paid for in cash—cash
transactions are typically better received.
Earnings Growth
Excess acquiror returns at announcement were higher
when the target had low projected earnings-growth
rates.
One reason is that companies with low projected
growth rates are often in mature industries.
Acquisitions of such companies can increase
shareholder value through operational synergies.
Companies tend to overpay for growth.
Takeover Methods
Tools Used To Acquire Companies
Proxy fight Tender Offer
Acquisition Merger
Leveraged Management
Buy-Out Buy-Out
Takeover Defenses
• White Knight - Friendly potential acquirer sought
by a target company threatened by an unwelcome
acquirer.
• Shark Repellent - Amendments to a company
charter made to forestall takeover attempts.
• Poison Pill - Measure taken by a target firm to
avoid acquisition; for example, the right for existing
shareholders to buy additional shares at an attractive
price if a bidder acquires a large holding.
Level Stategy
A B
A B
A B
>=< >=<
A
A B
B
Strategic Alliances
What is the logic of strategic alliances?
Strategic alliances as a hybrid organizational form,

somewhere between markets and hierarchies.
Strategic alliances as a means to acquire knowledge
Strategic alliances add value to the partnering firms

through the organizational flexibility they provide
Strategic alliances avoid some of the “agency problems”

associated with organizational growth through M&A
Problem of opportunistic behaviour

Flexibility inherent in alliances facilitates experimentation
with new combinations or participants in the pursuit of new
technologies or marketing strategies.
The ability to experiment should be particularly valuable to

rapidly growing firms and the so-called high-tech firms that
compete in environments characterized by rapid rates of change in
product design and process technologies, with significant risks of
failure at the development stage, and rapid obsolesence of
products once they enter production.
Therefore, we expect to find alliances involving firms with high

growth potential or that operate in high-tech industries to be more
prevalent and contribute more value to the partnering firms than
alliances involving firms with limited growth opportunities or in
low-tech industries.
Level Stategy
A B
A B
A B
>=< >=<
A
A B
B
Khorana, A., Shivdadani, A., Stendevad, C. and Sanzhar, S. 2011.
Spin-offs: Tackling the Conglomerate Discount by ,
Journal of Applied Corporate Finance • Volume 23 Number 4 A Morgan Stanley Publication • Fall 2011

Mergers and Acquisitions

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Mergers and Acquisitions

The Value of Corporate

M&A Alliances Spin-Offs

Value >=< Value >=< Value

2. How to allocate 3. Coordination

Mergers as a Use for Surplus Funds

Free cash flow problem - agency effects

Hubris – tendency to overpay for targets

Acquiring Firm has high P/E ratio

Selling firm has low P/E ratio (due to low

After merger, acquiring firm has short

Long term, acquirer will have slower than

PV(AB) > PV(A) + PV(B) ???

Cost = Cash Paid – PVB

NPV = gain – cost

Economic Gain = PV (increased earnings) =

Post Merger Market Value:

Post merger share price = $492.5 / 100,000 = $49.25

Cost = Cash Paid – PVB

NPV = gain – cost

Gain = Δ PVAB = + €20

Cost = Cash Paid – PVB

NPV = gain – cost

Cost = value of shares issued – Target co Value

Equity financed transaction can signal to the market

In addition, takeover arbitrageurs tend to buy the

Equity financing is preferred for related diversification

and unrelated diversification is associated with debt financing.

Firms diversifying through acquisitions are more likely to use

those emphasizing internal development of new businesses depend

In contrast, transactions in which the target was a

Focused transactions may be more successful than diversifying

Cultural and social issues are often accentuated in

Acquisitions of public companies typically occur

Acquisitions of business units or private

Companies tend to overpay for growth.

Proxy fight Tender Offer

M&A Alliances Spin-Offs

Value >=< Value >=< Value

Strategic alliances as a hybrid organizational form,

Strategic alliances as a means to acquire knowledge

Strategic alliances add value to the partnering firms

Strategic alliances avoid some of the “agency problems”

Problem of opportunistic behaviour

The ability to experiment should be particularly valuable to

Therefore, we expect to find alliances involving firms with high

M&A Alliances Spin-Offs

Value >=< Value >=< Value

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