Chapter 26 mergers and acquisitions

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
26-2

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
26-3

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
26-4

Acquisitions
•
A firm can be acquired by another firm or individual(’s)
purchasing voting shares of the firm’s 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
26-5

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
26-6

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
26-7

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
26-8

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
26-9

Revenue Enhancement
•
Marketing gains
–
Advertising
–
Distribution network
–
Product mix
•
Strategic benefits

•
Market power
26-10

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
26-11

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
26-12

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)
26-13

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
26-14

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
26-15

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
26-16

Cash Acquisition
•
The NPV of a cash acquisition is
–
NPV = V
B
* – cash cost
•
Value of the combined firm is
–
V
AB
= V
A
+ (V
B
* - cash cost)

•
Often, the entire NPV goes to the target
firm
•
Remember that a zero-NPV investment is
not undesirable
26-17

Stock Acquisition
•
Value of combined firm
–
V
AB
= V
A
+ V
B
+ ∆V
•
Cost of acquisition
–
Depends on the number of shares given to the target
stockholders
–
Depends on the price of the combined firm’s stock after
the merger
•
Considerations when choosing between cash and
stock

–
Sharing gains – target stockholders don’t participate in
stock price appreciation with a cash acquisition
–
Taxes – cash acquisitions are generally taxable
–
Control – cash acquisitions do not dilute control
26-18

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
26-19

More (Colorful) Terms
•
Golden parachute

•
Poison put
•
Crown jewel
•
White knight
•
Lockup
•
Shark repellent
•
Bear hug
•
Fair price provision
•
Dual class capitalization
•
Countertender offer
26-20

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
26-21

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 company’s

stockholders
•
Split-up – company is split into two or more
companies, and shares of all companies are
distributed to the original firm’s shareholders
26-22

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?
26-23

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?
26-24

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 V
B
*?
–
What is ΔV?
26-25