Chapter 21

Fundamentals of
Corporate Mergers, Acquisitions,
Finance and Corporate Control
Fifth Edition

Slides by
Matthew Will

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Topics Covered

The Market for Corporate Control

Sensible Motives for Mergers
Dubious Reasons for Mergers
Evaluating Mergers
Merger Tactics
Leveraged Buy-Outs
The Benefits and Costs of Mergers

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The Merger Market

Methods to Change Management

Proxy battle for control of the board of directors
Firm purchased by another firm
Leveraged buyout by a group of investors
Divestiture of all or part of the firm’s business
units

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Recent Mergers

Payment
Acquiring Company Selling Company ($ billions)
JP Morgan Chase Bank One Corp 58.8
Proctor & Gamble Gillette Co. 57.0
Bank of America Corp. FleetBoston Financial Grp 49.3
Cingular Wireless AT&T Wireless 41.0
Sprint Corp. Nextel Communications 35.2
Johnson & Johnson Guidant Corp. 25.4
ChevronTexaco Unocal Corp. 16.4
Anthem Inc. WellPoint Health Networks 16.4
SBC Corp. AT&T Corp. 16.0
Verizon MCI 8.5

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The Merger Market

Tools Used To Acquire Companies

Proxy Contest Tender Offer

Acquisition Merger

Leveraged Management
Buy-Out Buy-Out

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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

$
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Sensible Reasons for Mergers

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

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Sensible Reasons for Mergers

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

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Sensible Reasons for Mergers

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.

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Dubious Reasons for Mergers

Diversification
Investors should not pay a premium for
diversification since they can do it themselves.

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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.

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Dubious Reasons for Mergers

The Bootstrap Game

World Enterprises
World Enterprises (after buying Muck
(before merger) Muck and Slurry and Slurry)
EPS $2.00 $2.00 $2.67
Price per share $40.00 $20.00 $40.00
P/E Ratio 20 10 15
Number of shares 100,000 100,000 150,000
Total earnings $200,000 $200,000 $400,000
Total market value $4,000,000 $2,000,000 $6,000,000
Current earnings
per dollar invested
in stock $0.05 $0.10 $0.067

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Evaluating Mergers

Questions
Isthere 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)

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Evaluating Mergers

Economic Gain

Economic Gain = PV(increased earnings)

New cash flows from synergies

=
discount rate

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Evaluating Mergers
Example - Given a 20% cost of funds, what is the
economic gain, if any, of the merger listed below?

Cislunar Foods Targetco Combined Company

Revenues 150 20 172 (+2)
Operating Costs 118 16 132 (-2)
Earnings 32 4 40 (+4)

4
Economic Gain = = $ 20
.20

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Evaluating Mergers

Estimated net gain

Estimated net gain = DCF valuation of target including synergies

- cash required for acquisition

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Merger Tactics
White Knight - Friendly potential acquirer sought
by a target company threatened by an unwelcome
suitor.
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.

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Leveraged Buy-Outs

Unique Features of LBOs

Large portion of buy-out

financed by debt

Shares of the LBO no longer

trade on the open market

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Leveraged Buy-Outs

Potential Sources of Value in LBOs

Junk bond market
Leverage and taxes
Other stakeholders
Leverage and incentives
Free cash flow

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