Mergers and Acquisitions

Arzac, Chapter 9
 Mergers
• many people including Warren Buffett have expressed skepticism of the
power of mergers:
• Many managements apparently were overexposed in impressionable
childhood years to the story in which the imprisoned handsome prince
is released from a toad’s body by a kiss from a beautiful princess.
Consequently, they are certain their managerial kiss will do wonders
for the profitability of Company T(arget) … Investors can always buy
toads at the going price for toads. If investors instead bankroll
princesses who wish to pay double for the right to kiss the toad, those
kisses had better pack some real dynamite. We’ve observed many
kisses but very few miracles. Nevertheless, many managerial
princesses remain serenely confident about the future potency of their
kisses – even after their corporate backyards are knee-deep in
unresponsive toads… We have tried occasionally to buy toads at
bargain prices with results that have been chronicled in past reports.
Clearly our kisses fell flat. We have done well with a couple of princes
– but they were princes when purchased. At least our kisses didn’t
turn them into toads. And, finally, we have occasionally been quite
successful in purchasing fractional interests in easily identifiable
princes at toadlike prices.
 M&As
• changing forces driving mergers:
• technological change
• globalization and freer trade
• deregulation
• economies of scale, scope, and technological catch-up
• change in industry organization
• individual entrepreneurship
• macroeconomic factors
** Weston, Siu, and Johnson (2001)
• mergers vs. tender offers
• types
 Changes in Ownership Structure

• exchange offers
• leverage recapitalizations
• dual-class recapitalizations
• share repurchases
• LBOs, MBOs
• ESOPS
 Control of Decision Powers
• compensation arrangements
• proxy contest
• premium buy-backs (greenmail)
• takeover defenses
• stakeholder relationships
• ethics and reputation
 Theories of Mergers
• efficiency increases (restructuring)
• operating synergies
• financial synergy
• information
• hubris
• agency problems
Pattern of Gains Related to Takeover Theories
(with value changes referring to movements in prices of securities of firms)

Motive Total Gains Gains to Target Gains to Acquirer

Efficiency and/or synergy + + +

Hubris 0 + -
Agency problems - + -
 Forms of Transaction
• merger
• acquisition
• of assets
• of stock
• tax implications
• legal implications
 Form of Transaction
• stock purchase
• avoids tax at corporate level
• acquirer can use NOL of target
• sh of target taxed on capital gain
• acquirer can not step-up basis of target’s assets for tax purposes
• asset purchase
• seller is subject to corporate taxes
• buyer can step-up basis and amortize goodwill over 15 years
• buyer can not use NOLs of target
• merger
• forward merger
• reverse subsidiary merger
 Example 1
• Assume the buyer acquires a debt-free target for
$100 cash, the target’s tax basis in the assets is $40,
the target shareholders’ basis in the stock is $15, and
the fair MV of the stock was $70 prior to the
acquisition. Let the corporate tax rate be 40%, the
personal tax rate on capital gains be 20%, and
assume that all the gain to the seller is classified as
capital gain and the buyer’s price in excess of the
target’s basis is allocated to goodwill. Look at the
proceeds to the target using both a stock purchase
and an asset purchase.
• Review Example 2 and 3 in the text.
 Returns in M&As
• Kaplan and Weisbach (1992), Servaes (1991),
and Mulherin and Boone (2000)
• mergers in banking industry
• Becher (2000) – looked at because of increased
number of bank mergers that occurred around
industry deregulation
• evidence that bank mergers created wealth
• target returns
• bidder returns
 Value of Mergers
• VC = VA + VT + Synergies – Cash
• Premium = PT – VT
• Premium = pc*m + cash
• Acquirer’s Gain = Synergies – Premium
• Acquirer’s Gain + Seller’s Gain = Synergies
• pC = VC / (n + m)
or pC = (VA + VT + Synergies – Cash)/(n + m)
where n = # of old shares of acquirer
and m = # of shares issued to target shareholders
• Break-Even Synergies = Premium = mpA + Cash – VT
• GainA = Synergy - Premium
 Accretion/Dilution Analysis
• alternate way to look at the impact of the
merger to the shareholders of the acquirer
• find pro-forma EPS for merged firm for year
prior to merger and then years after also
• for share exchange, combine NI and divide by
new number of shares outstanding
• if new EPS is > EPS of acquirer, then there is
accretion if new EPS < EPS of acquirer, then there
is dilution
 Merger Analyses
• terms of the merger
• financing the merger
• break-even synergies
• financial model of the merger
• accretion-dilution analysis
• free cash-flow valuation
• stress-testing and scenario analysis
Balance Sheet XYZ Inc. as of 12/31/2004
Cost Fair Value
Current Assets
Cash and marketable securities 14,000 14,000
Accounts Receivable 86,702 81,523
Inventories
Raw Materials 34,671 45,123
Works in Progress 18,790 19,342
Finished Goods 70,415 85,457
123,876 149,922
Other Current Assets 11,500 11,500
Total Current Assets 236,078 256,945

Investments 25,460 38,634

Net PP&E 987,234 1,470,381
Intangible Assets 265,211 143,782
Total Assets 1,513,983 1,909,742

Current Liabilities
ST Debt and Current LTD 43,784 42,512
Accounts Payable 56,234 54,318
Accrued Expenses 2,840 2,840
Taxes Payable 8,128 8,128
LT Debt 335,578 310,456
Deferred Income Taxes 8,561 8,561
Total Liabilities 455,125 426,815

Preferred Stock 249,870 229,455

Common Stock and Retained Earnings 808,988 1,253,472
Total Net Worth 1,058,858 1,482,927
Total Liabilities and Equity 1,513,983 1,909,742
Balance Sheet XYZ Inc. as of 12/31/2004
ABC XYZ Eliminations and Adjustments
Current Assets Debit Credit Consolidated
Cash and marketable securities 34,021 14,000 48,021
Accounts Receivable 196,032 81,523 277,555
Inventories 298,723 149,922 448,645
Other Current Assets 30,044 11,500 41,544
Total Current Assets 558,820 256,945 815,765

Investments 1,554,230 38,634 1,500,000 92,864

Net PP&E 3,568,229 1,470,381 5,038,610
Intangible Assets
Goodwill 246,528 246,528
Other 789,541 143,782 933,323
Total Assets 6,470,820 1,909,742 7,127,090

Current Liabilities
ST Debt and Current LTD 67,834 42,512 110,346
Accounts Payable 108,340 54,318 162,658
Accrued Expenses 4,567 2,840 7,407
Taxes Payable 12,690 8,128 20,818
LT Debt 1,890,450 310,456 2,200,906
Deferred Income Taxes 32,189 8,561 40,750
Total Liabilities 2,116,070 426,815 2,542,885

Preferred Stock 229,455 229,455

Common Stock and Retained Earnings 4,354,750 1,253,472 1,500,000 246,528 4,354,750
Total Net Worth 4,354,750 1,482,927 4,584,205
Total Liabilities and Equity 6,470,820 1,909,742 7,127,090
 B’s acquisition of T

B T

Pre-announcement stock price $ 30 $ 22

Net income (million) $ 80 $ 37.50

Shares outstanding (million) 40 15

EPS $ 2.00 $ 2.50

P/E 15 8.8

Market value (million) $1200 $330