Mergers and Acquisitions

(M&A)
Chapter 29

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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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Key Concepts and Skills

• Be able to define the various terms associated with
M&A activity
• Understand the various reasons for mergers and
whether or not those reasons are in the best interest
of shareholders
• Understand the various methods for paying for an
acquisition
• Understand the various defensive tactics that are
available
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Outline
• The Basic Forms of Acquisitions
• Synergy
• Sources of Synergy
• Dubious Reasons for Acquisitions
• The NPV of a Merger
• Friendly versus Hostile Takeovers
• Defensive Tactics
• Do Mergers Add Value?
• The Tax Forms of Acquisitions
• Accounting for Acquisitions
• Going Private and Leveraged Buyouts (LBO)
• Divestitures and Restructurings
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The Basic Forms of Acquisitions

• There are three basic legal procedures that one

firm can use to acquire another firm:

• Merger or Consolidation

• Acquisition of Stock

• Acquisition of Assets
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Merger versus Consolidation

• Merger
• One firm is acquired by another
• Acquiring firm retains name and acquired firm
ceases to exist
• Consolidation
• Entirely new firm is created from combination
of existing firms
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Merger / Consolidation

• Advantage
• Legally simple
• Disadvantage
• Must be approved by stockholders of both
firms
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Acquisition of Stock
• A firm can be acquired when another firm or
individual(s) purchases voting shares of the firm’s
stock
• Tender offer – public offer to buy shares on the
market
• Acquisition of Stock:
• No stockholder vote for approval required
• Can deal directly with stockholders, even if management
is unfriendly
• May be delayed if some target shareholders hold out for
more money – complete absorption requires a merger
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Acquisition of Assets
• A firm can be acquired when another firm buys
most or all of its assets
• The target firm does not necessarily cease to
exist; it just sells off its assets
• This type of acquisition requires a formal vote of
shareholders of the selling firm
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Acquisitions
• Classifications
• Horizontal – both firms are in the same
industry
• Vertical – firms are in different stages of the
production process
• Conglomerate – firms are unrelated
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Varieties of Takeovers
Takeover: Control of a firm
transfers from one group of Merger
shareholders to another

Acquisition Acquisition of Stock

Takeovers Proxy Contest Acquisition of Assets

Going Private
(LBO or MBO)
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Synergy
• The positive incremental net gain associated with the
combination of two firms through M&As
• Some M&As create synergies because the firm can either
cut costs or use the combined assets more effectively
• Most acquisitions fail to create value for the acquirer
• The main reason why they fail to integrate two companies
after a merger
• Intellectual capital often walks out the door when
acquisitions are not handled carefully
• Traditionally, acquisitions deliver value when they allow for
scale economies or market power, better products and
services in the market, or learning from the new firms
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Synergy
• Suppose firm A is contemplating acquiring firm B.
The whole is worth more than the sum of the parts.
• The synergy from the acquisition is

Synergy: △V = VAB – (VA + VB)

• The synergy of an acquisition can be determined
from the standard discounted cash flow model:

T
S
DCFt
Synergy = (1 + R)t
t=1
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Sources of Synergy
• Revenue Enhancement
• Cost Reduction
• Replacement of ineffective managers
• Economy of scale or scope

• Tax Gains
• Net operating losses
• Unused debt capacity

• Reduced required investment in working capital and

fixed assets
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Calculating Value
• Avoiding Mistakes:

• Do not ignore market values

• Estimate only Incremental cash flows

• Use the correct discount rate

• Do not forget transactions costs

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Synergy

• This is generally a good

reason for a merger

• Examine whether the

synergies create enough
benefit to justify the cost
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Dubious Reasons for Acquisitions

• Earnings Growth
• If there are no synergies or other benefits to the merger,
then the growth in EPS is just an artifact of a larger firm
and is not true growth (i.e., an accounting illusion)
• In this case, the P/E ratio should fall because the
combined market value should not change
• Diversification
• Shareholders who wish to diversify can accomplish this
at much lower cost with one phone call to their broker
than can management with a takeover
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The NPV of a Merger

• Typically, a firm would use NPV analysis when

making acquisitions
• The analysis is straightforward with a cash offer,

but it gets complicated when the consideration is

stock
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Cash Acquisition
• The NPV of a cash acquisition is:
• NPV = VB* – cash paid = (VB + ΔV) – cash paid

• Value of the combined firm is:

• VAB = VA + (VB* – cash paid)

• Often, the entire NPV goes to the target firm

• Remember that a zero-NPV investment may
also be desirable
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Stock Acquisition
• Value of the combined firm:
• VAB = VA + VB* = VA + VB + △V

• The NPV of a stock acquisition:

• NPV = VB* – Purchase price

• Purchase price of stock acquisition:

• Depends on the number of shares given to the
target’s stockholders
• Depends on the price of the combined firm’s stock
after the merger
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Stock vs. Cash Acquisition

• Considerations when choosing between cash
and stock:
• Sharing gains – target stockholders do not
participate in stock price appreciation with a cash
acquisition
• Taxes – cash acquisitions are generally taxable
• Control – cash acquisitions do not dilute control
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Friendly vs. Hostile Takeovers

• In a friendly merger, both companies’ management

are receptive
• In a hostile merger, the acquiring firm attempts to

gain control of the target without their approval

• Tender offer

• Proxy fight
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Defensive Tactics
• Corporate charter

• Classified board (i.e., staggered elections)

• Supermajority voting requirement

• Golden parachutes

• Standstill agreements

• Targeted repurchase (a.k.a. greenmail)

• Poison pills (Share rights plans)

• Leveraged buyouts (LBO) and Management buyouts

(MBO)
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More (Colorful) Terms

• Poison put
• Crown jewel
• White knight
• Lockup
• Shark repellent
• Bear hug
• Fair price provision
• Dual class capitalization
• Counter-tender offer
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Do Mergers Add Value?

• Shareholders of target companies tend to earn
excess returns in a merger:
• Shareholders of target companies gain more in a
tender offer than in a straight merger
• Target firm managers have a tendency to oppose
mergers, thus driving up the tender price
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Do Mergers Add Value?

• Shareholders of bidding firms earn a small excess
return in a tender offer, but none in a straight merger:
• Anticipated gains from mergers may not be achieved
• Bidding firms are generally larger, so it takes a larger
dollar gain to get the same percentage gain
• Management may not be acting in stockholders’ best
interest
• Takeover market may be competitive
• Announcement may not contain new information about
the bidding firm
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The Tax Forms of Acquisition

• If it is a taxable acquisition, selling shareholders need to
figure their cost basis and pay taxes on any capital gains.
• Generally, cash acquisition is taxable

• If it is not a taxable event (tax-free acquisition),

shareholders are deemed to have exchanged their old
shares for new ones of equivalent value.
• Generally, stock-for-stock acquisition
• Business purpose, not solely to avoid taxes
• Continuity of equity interest – stockholders of target firm
must be able to maintain an equity interest in the combined
firm
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Accounting for Acquisitions

• The Purchase Accounting Method:
• Assets of the acquired firm are reported at the fair market
value
• Any excess payment above the fair market value is
reported as “goodwill” which is the difference between
purchase price and estimated fair market value of net
assets
• Historically, goodwill was amortized. Now it remains on the
books until it is deemed “impaired.” Assets are essentially
marked-to-market annually and goodwill is adjusted and
treated as an expense if the market value of the assets has
decreased
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Going Private and Leveraged Buyouts

• A small group of investors, including the existing
management, buys the firm from the shareholders
and takes it private
• Since it is financed with a lot of debt, it is a
leveraged buyout (LBO)
• The extra debt provides a tax deduction for the new
owners, while at the same time turning the previous
managers into owners
• This reduces the agency costs of equity
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Divestitures and Restructurings

• Divestiture – company sells a piece of itself to another
company
• Split-up – company is split into two or more companies,
and shares of all companies are distributed to the original
firm’s shareholders
• Equity carve-out – company creates a new company out
of a subsidiary and then sells a minority interest to the
public through an IPO
• Spin-off – company creates a new company out of a
subsidiary and distributes the shares of the new company to
the parent company’s stockholders
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Quick Quiz
• What are the different methods of achieving a
takeover?
• How do we account for acquisitions?
• What are some of the reasons cited for mergers?
Which of these may be in stockholders’ best interest
and which generally are not?
• What are some of the defensive tactics that firms
use to thwart takeovers?
• How can a firm restructure itself? How do these
methods differ in terms of ownership?