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Chapter 26 Mergers and Acquisitions

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills


Be able to define the various terms associated with M&A activity Understand the various reasons for mergers and acquisitions and whether or not these reasons are in the best interest of shareholders Understand the various methods for paying for an acquisition and how to account for it Understand the various defensive tactics that are available Understand how to value the transaction and estimate the gains from the merger or acquisition
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Chapter Outline
The Legal Forms of Acquisitions Taxes and Acquisitions Accounting for Acquisitions Gains from Acquisition Some Financial Side Effects of Acquisitions The Cost of an Acquisition Defensive Tactics Some Evidence on Acquisitions: Do M&A Pay? Divestitures and Restructurings
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Merger versus Consolidation


Merger
One firm is acquired by another Acquiring firm retains name and acquired firm ceases to exist Advantage legally simple Disadvantage must be approved by stockholders of both firms

Consolidation
Entirely new firm is created from combination of existing firms

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Acquisitions
A firm can be acquired by another firm or individual(s) purchasing voting shares of the firms stock Tender offer public offer to buy shares Stock acquisition
No stockholder vote 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

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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Takeovers
Control of a firm transfers from one group to another Possible forms
Acquisition
Merger or consolidation Acquisition of stock Acquisition of assets

Proxy contest Going private

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Taxes
Tax-free 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 Generally, stock for stock acquisition

Taxable acquisition
Firm purchased with cash Capital gains taxes stockholders of target may require a higher price to cover the taxes Assets are revalued affects depreciation expense

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Accounting for Acquisitions


Pooling of interests accounting no longer allowed Purchase Accounting Assets of acquired firm must be reported at fair market value Goodwill is created difference between purchase price and estimated fair market value of net assets Goodwill no longer has to be amortized 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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Synergy
The whole is worth more than the sum of the parts Some mergers create synergies because the firm can either cut costs or use the combined assets more effectively This is generally a good reason for a merger Examine whether the synergies create enough benefit to justify the cost

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Revenue Enhancement
Marketing gains
Advertising Distribution network Product mix

Strategic benefits Market power

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Cost Reductions
Economies of scale
Ability to produce larger quantities while reducing the average per unit cost Most common in industries that have high fixed costs

Economies of vertical integration


Coordinate operations more effectively Reduced search cost for suppliers or customers

Complimentary resources

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Taxes
Take advantage of net operating losses
Carry-backs and carry-forwards Merger may be prevented if the IRS believes the sole purpose is to avoid taxes

Unused debt capacity Surplus funds


Pay dividends Repurchase shares Buy another firm

Asset write-ups

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Reducing Capital Needs


A merger may reduce the required investment in working capital and fixed assets relative to the two firms operating separately Firms may be able to manage existing assets more effectively under one umbrella Some assets may be sold if they are redundant in the combined firm (this includes reducing human capital as well)

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General Rules
Do not rely on book values alone the market provides information about the true worth of assets Estimate only incremental cash flows Use an appropriate discount rate Consider transaction costs these can add up quickly and become a substantial cash outflow

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EPS Growth
Mergers may create the appearance of growth in earnings per share 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 In this case, the P/E ratio should fall because the combined market value should not change There is no free lunch

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Diversification
Diversification, in and of itself, is not a good reason for a merger Stockholders can normally diversify their own portfolio cheaper than a firm can diversify by acquisition Stockholder wealth may actually decrease after the merger because the reduction in risk, in effect, transfers wealth from the stockholders to the bondholders
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Cash Acquisition
The NPV of a cash acquisition is
NPV = VB* cash cost

Value of the combined firm is


VAB = VA + (VB* - cash cost)

Often, the entire NPV goes to the target firm Remember that a zero-NPV investment is not undesirable

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Stock Acquisition
Value of combined firm Cost of acquisition
VAB = VA + VB + V Depends on the number of shares given to the target stockholders Depends on the price of the combined firms stock after the merger

Considerations when choosing between cash and stock


Sharing gains target stockholders dont 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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Defensive Tactics
Corporate charter
Establishes conditions that allow for a takeover Supermajority voting requirement

Targeted repurchase (a.k.a. greenmail) Standstill agreements Poison pills (share rights plans) Leveraged buyouts

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More (Colorful) Terms


Golden parachute Poison put Crown jewel White knight Lockup Shark repellent Bear hug Fair price provision Dual class capitalization Countertender offer

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Evidence on Acquisitions
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

Shareholders of bidding firms, on average, do not earn or lose a large amount


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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Divestitures and Restructurings


Divestiture company sells a piece of itself to another company 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 companys stockholders Split-up company is split into two or more companies, and shares of all companies are distributed to the original firms shareholders

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Quick Quiz
What are the different methods for achieving a takeover? How do we account for acquisitions? What are some of the reasons cited for mergers? Which 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?

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Ethics Issues
In the case of takeover bids, insider trading is argued to be particularly endemic because of the large potential profits involved and because of the relatively large number of people in on the secret.
What are the legal and ethical implications of trading on such information? Does it depend on who knows the information?

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Comprehensive Problem
Two identical firms have yearly after-tax cash flows of $20 million each, which are expected to continue into perpetuity. If the firms merged, the after-tax cash flow of the combined firm would be $42 million. Assume a cost of capital of 12%.
Does the merger generate synergy? What is VB*? What is V?

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End of Chapter

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