E10 Corporate Finance

Module 6

Mergers and acquisitions

Introduction
We are examining mergers and acquisitions as they are becoming more
common. We shall start our discussion by looking at the legal structure of
mergers and acquisitions together with accounting matters. In this module we
will concentrate on the important issues regarding mergers and acquisitions.
After reading this you will come to know about sensible motives behind
mergers and acquisitions.

Mergers and acquisitions (M&A) and corporate restructuring are a big part of
the corporate finance world. Mergers prove very beneficial for the economy
if these are successful. Some countries force poorer companies to merge with
established organisations for the betterment of them as well as the economy.
And it is no wonder we hear about so many of these transactions; they happen
all the time. Next time you flip open the newspaper’s business section, odds
are that at least one headline will announce some kind of M&A transaction.
Let us go through the definitions of merger and acquisition.

The combination of two or more companies, generally by offering the

stockholders of one company securities in the acquiring company in
exchange for the surrender of their stock, is known as merger.

A corporate action in which a company buys most, if not all, of the target
company’s ownership stakes in order to assume control of the target firm is
said to be an acquisition. Acquisitions are often made as part of a company’s
growth strategy whereby it is more beneficial to take over an existing firm’s
operations and niche compared to expanding on its own. Acquisitions are
often paid in cash, the acquiring company’s stock or a combination of both.

In this module we will also discuss the benefits that the firms get after
mergers and acquisitions. Not all mergers and acquisitions are successful and
failure to produce the desired results is also focused on in thismodule. We
have also elaborated the reasons behind the failures of mergers and
acquisitions.

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Upon completion of this module you will be able to:

 define mergers and acquisitions.

 describe the driving force behind mergers.
 describe types of mergers and acquisitions.
Outcomes  narrate motives behind mergers and acquisitions.
 describe the legal process involved in mergers and acquisitions.
 identify the benefits likely to be realised from acquisitions.
 determine an appropriate pricing structure for a takeover bid.
 identify the reasons of mergers failure.

Merger: Combining the resources of two or more

companies.

Acquisition of A firm purchases the voting shares of another firm

stock: in exchange of cash, shares or some other
Terminology securities.

Acquisition of A firm acquires another firm via buying most or

assets: all of assets of acquiring firm

Horizontal merger: The combining of two companies that are in direct

competition with one another.

Vertical merger: The merger between a customer and a company or

a supplier and a company.

Conglomeration: The merger of two companies that have no

common business ties.

Market-extension Companies dealing in the same products and

merger: different markets, join hands.

Product-extension The product extension merger occurs between two

merger: business organisations that deal in products that
are related to each other and operate in the same
market.

Congeneric merger: Two merging firms are in the same general

industry, but they have no mutual buyer/customer
or supplier relationship.

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Reverse merger: Usually large company takes over smaller

company but whenever a smaller company takes
over a larger one.

Legal forms of acquisition

There are three legal procedures that can be used to acquire a firm
1. Merger or consolidation
2. Acquisition of stock
3. Acquisition of assets

1. Merger or consolidation

A merger is the combination of two firms. In the case of merger the two firms
completely absorb each other. The acquiring firm retains its name and
identity and owns all the assets and liabilities of acquired firm whereas the
acquired firm does not have right to retain its name and identity. In
consolidation, same as merger, there are two firms one is acquiring all the
assets and liabilities of the other. The difference between merger and
consolidation is that after consolidation a new firm is created. Both the
acquiring and acquired firms cease to retain their identity. After consolidation
a new firm arises at the business horizon.
2. Acquisition of stock

The second way a firm can use to acquire another firm is to purchase the
voting shares of a firm in exchange for cash, shares or some other securities.
This procedure of buying or acquiring the firm often starts as a private offer
from one company to another. The direct offer of one company’s shares to
another company is known as tender offer. So it can be rightly said that
acquisition of stock takes place through tender offer.
3. Acquisition of assets

A firm can be acquired by another firm if the acquiring firm buys most or all
of assets of acquiring firm. In this case, the acquiring firm is not restricted to
exist. This type of acquisition needs formal vote of all the existing
shareholders. One benefit in this type of acquisition is that rights of minority
shareholders are preserved.

What is merger?
Merger: Combination of all resources of two or more firms.

The word merger has been derived from the word merge which literally
means to make a combination with another thing. Merger means the complete

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absorption of one firm by another. In the business world, often companies

combine with some other companies to get various economic, social or
marketing benefits.

Companies want to become richer in case of assets and equity. Merger is the
best channel to get richer. Mergers also involve risks and some issues but
instead companies merge after proper analysis and research. Mergers are
going to be very common in today’s world due to incentives that acquiring
company gets after successful accomplishment of mergers.
Types of mergers
 Horizontal merger
 Vertical merger
 Conglomeration
 Market-extension merger
 Product-extension merger
 Congeneric merger
 Reverse merger

Horizontal merger

The combining of two companies that are in direct competition with one
another is called horizontal merger. In other words, they are trying to sell the
same product to customers who are in a common market. The merger
between competitors is said to be horizontal merger. This type of merger can
either have a very large effect or little to no effect on the market. When two
extremely small companies combine, or horizontally merge, the results of the
merger are less noticeable. These smaller horizontal mergers are very
common.

Vertical merger

The merger between a customer and a company or a supplier and a company

is vertical merger. Suppose a garments company merging with a cotton
production company. This would be an example of the supplier merging with
the producer and is the essence of vertical mergers. This type of merger can
be viewed as anticompetitive because it can often rob supply business from
its competition. Antitrust concerns are a focal point of investigation if
competition is hurt.

Conglomeration

A conglomeration is the merger of two companies that have no common

business ties. They do not deal in the same products or same markets. There
are two main types of conglomerate mergers – the pure conglomerate merger
and the mixed conglomerate merger. The pure conglomerate merger is one

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where the merging companies are doing businesses that are totally unrelated
to each other. The mixed conglomerate merger is that where the companies
merging work for the expansion of products or services they are already
providing.

Market-extension mergers

Companies dealing in the same products and different markets, when join
hands, are said to be in market-extension mergers. The major purpose of this
type of merger is to get control over the market and to ensure a bigger client
base.

Product-extension merger

The product extension merger occurs between two business organisations that
deal in products that are related to each other and operate in the same market.
The major purpose behind this merger is to get large number of customers
and to ensure high profits.

Congeneric merger

Congeneric mergers take place where two merging firms are in the same
general industry, but they have no mutual buyer/customer or supplier
relationship, such as a merger between a bank and a leasing company.

Reverse merger

Usually a large company takes over a smaller company but whenever a

smaller company takes over a larger one it’s known to be reverse merger.

Acquisition
Acquisition is a corporate action in which a company buys, if not all, most of
the assets of another company. Sometimes, according to the needs,
circumstances and funds availability a company prefers to buy assets of other
company rather get combined with it. This scenario is said to be acquisition.
Acquisition in preference comes after merger.

In this acquiring, a firm is partially absorbed by another company and

somehow the rights of shareholders are also preserved.
Classification of acquisition
 Friendly acquisition
 Hostile acquisition.

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Friendly acquisition

In friendly acquisition, the companies’ executives negotiate and all the

decisions are taken on a mutual basis.

Hostile acquisition

In a hostile acquisition there is no negotiation among the executives. The

whole process is performed by bidder and the bidder continues to seek it even
the target firm is unwilling.
Difference between mergers and acquisitions

Both the terms “mergers” and “acquisitions” are used interchangeably but
they have slight differences between them. Merger is a mutual decision and
occurs when two organisations are agreed on being one while acquisition is
buying of one organisation by another. Mergers can be categorised as
horizontal, vertical, conglomerate etc. while acquisitions can be categorised
as friendly acquisition or hostile acquisition. One of the differences between
these two is of financial resources. Merger may not involve cash while
acquisition needs cash put up.
Sensible motives for mergers

The motives for which mergers come into existence are:

 Economies of scale
 Optimum utilisation of resources
 Economies of vertical integration
 Use of surplus funds
 Diversification.

Economies of scale

Economies of scale imply an opportunity to spread fixed cost over a larger

volume of output to enhance profit ratio. By combining two firms, the new
one comes in the form of a mega setup which needs larger amount of material
procurement for competing with same level firms. This procurement level
reduces fixed costs by spreading it across the larger scale output.

Optimum utilisation of complementary resources

Sometimes small firms have ample talent but due to their size they lack the
resources to compete in the market. Whereas in the same place larger firms
may have resources but lack talent like engineering. In this case if these two
firms merge, combining their resources which are complementary to each
other, both will be highly benefited after being merged.

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Economies of vertical integration

Vertical integration means to get control over the whole production process
by combining backward with your suppliers and forward with your
customers. To enjoy economies of vertical integration, companies merge with
their suppliers and then move towards forward integration. This reduces
transport cost as well as improving availability of material.

Use of surplus funds

Firms working in mature industries have surplus funds which can be utilised
either by paying a dividend to shareholders or by repurchasing shares. But a
rational manager never considers these options. Firms can buy shares of other
companies forming a merger. So a merger provides a proper channel for
utilisation of surplus funds.

Diversification

The word diversification means to spread your investment to enhance return

as well as to minimise risk. Merger is a good way to diversify your
investment. You can make a portfolio by buying shares of different
companies.
Gains from mergers and acquisitions
 Synergy
 Cost reduction
 Revenue enhancement
 Tax benefits
 Reduction in capital needs
 Check on inefficient management.

Synergy

The positive incremental net gain associated with the combination of two
firms either through merger or acquisition is called synergy. The first and
foremost benefit for which one firm acquires another through any mode is
synergy. It adds value to the firm either by increasing assets, goodwill or
equity. A firm will acquire another firm if the value of a merged firm is
greater than the individual value of firms before merger. In equation form it
represents

Value (A+B) > Value (A) + Value (B)

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Synergic effect can also be described as the difference between the values of
the combined firm and the sum of the values of the firms as separate entities.
When this difference between the values is positive, it is a sign of value
addition to the acquiring firm. But when this difference indicates a negative
sign firms will never decide to make a merger. By checking incremental cash
flows you can determine the incremental value of an acquisition. These are
the cash flows for the combined firm exceeding the separate cash flows
generated by individual firms before merger.

Incremental cash flows can be broken down into four parts as:

Incremental cash flow = increase in revenue + reduction in cost +

reduction in tax + reduction in capital requirements

On the basis of this breakdown, a merger will work only if these components
show beneficial effects to the acquiring firm.

Cost reduction

Cost of the company is reduced by economies of scale and economies of

vertical integration. Savings related to economies of scale (for example,
fewer manufacturing plants each having improved capacity utilisation; more
effective use of corporate resources such as IT). Economies of vertical
integration (in 2001 there was a major move for media companies to acquire
organisations that produce content that can be better used in a larger
business). An example would be the Canwest Global Communications
acquisition of the Canadian daily newspapers of Hollinger Inc. in 2001.

Tax savings

Under Canadian tax law, net operating losses can be carried back for up to
three years and carried forward for up to seven. These losses are written off
as expenses which reduce income level and alternatively tax imposed
becomes less. Unfortunately, it is often the case that losses expire before they
can be utilised due to the seven-year time limit. Therefore a company with
net operating losses carried forward may be a worthwhile target. Eatons was
a recent example of a company being acquired where its principal asset was
tax losses. Sears Canada acquired Eatons to utilise the losses in a high-end
department store operation that it set up in 2000. This was a fairly short run
decision, with Sears’ decision to convert the Eaton stores to Sears outlets in
2002.

Revenue enhancement

By mergers and acquisitions businesses raise their income level to a large

extent. When a smaller company near to destruction is merged with a

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stronger company having a large market share, it can enhance its revenues.
The larger company will provide capital and all the other things needed to
survive in the market by which earnings of the smaller company will be
enhanced automatically. In another aspect savings or profit in business
increases when its costs are cut.

Profit = Revenue – Cost

According to this equation profit can be enhanced either by increasing sales

level or by decreasing cost. As discussed earlier, by merger you can reduce
your cost as well as your tax expense; when these two decrease net profit of
the business moves up.

Reduction in fixed and working capital

Benefits in these areas can include:

 Companies involved in manufacturing activities can reduce their
future capital expenditures since less capacity will sometimes be
required.
 Surplus assets can be sold to generate cash.
 Rationalisation of manufacturing and distribution facilities will
usually mean less capital is required after merger.

Check on inefficient management

In the success of any organisation, management plays a very vital role. If

management is effective as well as efficient, the company will grow speedily.
Management acts as a backbone for any organisation. Sometimes companies
merge with another sound management company to get the benefits of that
well managed company’s management. If your management is not doing
work efficiently, you prefer to merge with a company in industry having
sound management. New management will check points of inefficiency and
enhance the effectiveness of previous management.

Accounting for mergers and acquisitions

As a result of mergers and acquisitions, a company’s accounting statements
will change. As per the tax rules, we are looking at this from a Canadian
accounting perspective. Accounting treatment will vary in different
jurisdictions. At the date of the acquisition, companies will have to determine
the fair value of the net assets (total assets less liabilities) of the target
company. The difference between this fair value estimate and the purchase
price for the company is called goodwill. This is a new asset classified as an
intangible capital asset. Each year companies must assess whether the value
of this goodwill has been impaired at the date of preparing financial

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statements. If goodwill has been impaired, then companies must recognise an

impairment expense and reduce the value of goodwill by the amount of the
impairment. If the value of the goodwill has not been impaired then no
accounting entries take place and the value of goodwill is left as the amount
of goodwill at the purchase date.

All assets and liabilities of the target company are restated to their fair market
value at the date of purchase in the consolidated financial statements of the
acquirer. This usually leads to increased charges for amortisation of capital
assets amongst other things, which exerts downward pressure on reported
earnings. Why? If the fair value of a capital asset is higher than its net book
value of the target company’s accounting records, you will have a higher
capital asset value to amortise. The difference between the existing book
value and the fair value of the capital asset at purchase must be amortised
over the remaining useful life of the capital asset. Another example of this
type of increased expense is inventory. If inventory fair values are greater
than the book value of inventory at the date of purchase then the difference
between fair value and book value must be included in cost of goods sold
when the inventory is sold.
Structuring the purchase consideration

In this section we will examine what purchase consideration is best from the
perspective of an acquiring company shareholder. Should we go cash or
should we issue new shares? We will explore this issue by means of an
example. To keep things simple, the example will consider cash versus shares
only. In practice, many offers consist of a mixture of cash and shares.
Alternatively, the offer may be in shares but with a cash option.
Example: X takes over Y, making it a wholly owned subsidiary

The table below contains pre merger information concerning X and Y.

Table: Merger Information for Company X and Company Y

Particulars Company X Company Y

Price per common share $20 $10
Number of shares (millions) 25 10
Total market capitalisation (millions) $500 $100

It will not surprise you to find that X will have to pay more than $10 per
share to acquire Y. Company X will have to pay a takeover premium to be
successful with any bid. Let us suppose that a 50 per cent premium over
current market value is required to obtain the support of Y’s board of
directors. In the previous section, we saw that X would expect to obtain some
cash benefits from the acquisition arising from synergies between X and Y.
Let’s say that plants can be closed, head office personnel slashed, and prices
increased due to higher market share. Furthermore, a financial evaluation

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shows that the present value of the above benefits is $100 million. Therefore,
the value of Y to X is 100 + 100 = $200 million. We now examine the costs
of acquiring the shares in the two cases.

Case A: Cash acquisition

The acquisition cost of Y = 150% x 100 = $150 million

The NPV of this option = Value of Y – Acquisition cost (cash)

= 200 –150 = $50 million

Now, if the market has full access to all information considered by X’s board
and took the same view of the future then, the value of X after the merger
would be:

Pre-acquisition value of X + value of Y – cost of acquisition = 500 + 200 –

150 = $550 million.

Therefore, the stock price would be $550 million/25 million shares = $22
each, (i.e. gain in price of $20.0 per share).

Case B: Share acquisition

To make a stock-based offer for Y, X will have to issue new shares worth
$150 million. Since the current price of X is $20 per share, X will need to
issue 150 million/20 = 7.5 million new shares. Therefore, the number of X
shares issued and outstanding after the acquisition is 25 million (per table) +
7.5 million = 32.5 million shares. Now the value of the new bigger X is: 500
+ 200 = $700 million. Therefore, the market should value the shares in this
case at 700/32.5 = $21.54 each. If you go back to case A, you will see that the
share acquisition produces a lower price per share than the cash acquisition.

In fact, since the effect of the transaction is a stock price increase for X’s
shares you can argue that the lucky Y shareholders didn’t receive $15 each,
they actually received more. We know that Y shareholders received 7.5
million shares in X. At the price after the deal was done, these 7.5 million
shares were worth 7.5 million x 21.54 (per previous paragraph) = $161.55
million.

Now the net present value of this alternative is the value of Y including the
synergies – the cost (i.e., 200 million – 161.5 million = 38.45 million), which
is lower than the $50 million shown as the NPV in the cash offer.

If we compare the two cases, A and B, why is A better? If you think about it,
the result is not surprising. In A, when X pays cash, the existing X
shareholders get to keep all of the synergy benefits, whereas in B they have to
be shared with the shareholders of Y.

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Considerations in choosing cash vs. stock

Real life, alas, is often quite different from the sort of contrived examples we
put together. Here are some thoughts backed up by a cold dose of reality:
 Cash offers (which in reality will often involve borrowing at least
some of the funds) will be the most attractive on paper since synergy
gains belong entirely to the acquirer. Leverage adds to the attraction
because the cost of debt financing is tax-deductible interest. As we
saw in accounting, they typically produce higher earnings per share,
which is attractive from an investor relations perspective.
 Cash offers maintain control. Many public companies are dominated
by groups who wish to maintain control.
 The principal downsides of cash offers (which involve borrowing)
arise from the increased risk flowing from additional debt plus the
fact that these risks are borne by a smaller group of stockholders.

The negative aspects of borrowing to finance acquisitions are reinforced by

the recent experiences of:
 Extendicare, an operator of long-term care homes. Large United
States acquisitions produced some synergies, which were more than
offset by losses incurred due to changes in the Medicare system.
 Laidlaw, the largest operator of buses in North America. Heavy
losses arose from ambulance-based businesses acquired in the U.S.

Merger waves
Economic history has been divided into Merger Waves based on the merger
activities in the business world as:

Period Name Facet

1889-1904 First Wave Horizontal Mergers

1916-1929 Second Wave Vertical Mergers

1965-1989 Third Wave Diversified Conglomerate Mergers

Congeneric Mergers, Hostile

1992-1998 Fourth Wave
Takeover, Corporate Raiding

2000-to date Fifth Wave Cross-border Mergers

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Ways to acquire a company

 Acquisition with share/cash or a mixture
 Asset purchase: An alternative to acquiring shares

Acquisition with share/cash or a mixture

If an acquiring company wishes to acquire a target company, then it

commonly makes what is known as a tender offer. This is an offer made by
the acquiring company directly to the shareholders of the target. This can be
an unfriendly offer (made without the support of the board of the target
company) or can be a friendly offer that is supported by the target company’s
board. Either way the board of the target company has a responsibility to
determine the fairness of the offer being made. A fairness opinion is sought
from an investment-banking firm – and this may be expensive. In the case of
unfriendly moves, the board of the target will usually try to find other bidders
in order to get a higher price for the shares that are being sought. Bidders are
frequently seeking 100 per cent of the common shares of the target or
possibly some lesser number that provides a control position. Therefore a
condition of any tender offer is that a minimum number of shares must be
tendered, say 90 per cent. If the minimum is not tendered, then the acquiring
company has no obligation to proceed with the bid.

Asset purchase: An alternative to acquiring shares

Most large acquisitions you read about are transactions based on acquiring
the shares of a target company. The target itself may have a large number of
subsidiaries, which become subject to the control of the acquiring company
as a result of the transaction. Acquisition of shares is generally the easiest and
cheapest way to accomplish the goals of the bidder.

An alternative, which is relatively common among private companies, is an

asset purchase. Here the acquiring company purchases all the assets of the
target company (land, buildings, equipment, inventories, and so on) and may
take over liabilities and debt as part of the deal. The shareholders of the target
company must vote in favour of such a move, which will essentially leave a
corporate shell whose only asset will be cash. An asset purchase involves
more work on the part of the acquiring company since legal title to the assets
acquired will have to be obtained. The advantages to the acquirer are that it
will not be encumbered with any of the obligations of the target, (for
example, outstanding and potential lawsuits). This route can have major tax
drawbacks for the shareholders of the target company. This can mean that a
higher price may have to be paid to avoid acquiring the corporate structure
associated with the target.
Other concepts related to mergers and acquisitions
 Defensive strategies
 Going private and leveraged buy out

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 International mergers

Defensive strategies

No discussion on acquisitions is complete without some reference to

contested takeovers. In this section we briefly mention some of the
manoeuvres resorted to by a board wishing to fight off a predator. The one
manoeuvre you have likely heard of is a share rights plan (SRP) or ‘poison
pill’. This is a financial device designed to make unfriendly takeover attempts
unappealing if not impossible. These plans are set up such that should an
acquirer make a bid, existing shareholders become entitled to rights that make
it ruinously expensive for a bidder to proceed. The intention is to force all
bidders to negotiate with the target’s board of directors. Thus, a bidder
knowing that an SRP is in place (it is matter of public record), must negotiate
with the existing board and typically have the SRP set aside to allow a bid to
proceed.

Going private and leveraged buyouts

Leveraged buyout: A method of acquisition in which most of the percentage

of the purchase price is financed through leverage (borrowing). Shareholders
in public companies can benefit financially when their company is taken over
or acquired by another public company. As we saw previously in this block,
bidders have to pay a takeover premium to be successful. However, public
shareholders can also achieve a premium when their shares are bought out by
an existing control group or when management buys out the company via a
leveraged buyout (LBO).

For example, in 2001 Quebec Tel, a northern Quebec based telephone utility,
was taken private by controlling shareholder AGT, a U.S. company, and BCT
Telus. Following the acquisition of the public shares, a company is de-listed
from the stock exchange and reverts to being a regular private company.
Going private can produce attractive gains to public stockholders. If the
private company thereby created is an LBO, its success will be enhanced by
the magic of leverage. However, the undertaking has become much riskier
due to the obligation to service a high debt load.

International mergers

Mergers vary in popularity in various countries and will be subject to

different regulations, tax issues, and accounting treatment in the various
countries. Aside from the level of mergers within the same country there is
also activity in the merger area on the international realm. By this we are
referring to a company in one country merging with a company from a
different country. For example, you may have a U.S. corporation merging
with a British company. These international mergers can provide both
companies with benefits but they also increase the complications of the
merger process. With international mergers companies must be aware of the
regulations in place in the target company’s country.

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An acquiring company is not only faced with different regulations, they are
potentially faced with different cultures. This can make shareholders of the
target company reluctant to agree to the merger. It is important that
companies research both the regulatory aspects and any cultural aspects.
Many mergers fail when they are completed between two companies in the
same country because joining two companies with different cultures can
sometimes prove to be too much of a challenge. When you are entering the
mix international borders, potentially different customs and business norms
the chance of failure increases.

Why are international mergers attractive even with the increased risk?
Acquiring an existing company in a foreign country is often less expensive
than entering that market through the creation of a new company. If the
company is already established and going well, then acquiring the company
can use its good reputation to launch new products into a foreign market.
They are more likely to be purchased from a well-respected local company
than by a new foreign company. As with ‘local’ mergers, the target company
may have technology that is of benefit to the acquiring company and merging
may be viewed as the best means of gaining access to the technology. It may
also be that a company has certain rights to an idea or a product that the
acquiring company wants access to as well.

In addition to accessing products and new markets, the acquiring company is

expanding its potential market for new capital. The acquiring company can
potentially raise debt in the foreign country and issue shares in that country.
These avenues for debt and capital may not have been available as a foreign
company. Often the shareholders of the target company are interested in the
merger for reasons beyond those of a national merger. Through the exchange
of their shares for shares in an international company they cause a change to
the risk level of their investment portfolio. This can be viewed as positive or
negative depending on the shareholder’s overall portfolio and risk tolerance.
Although more factors need to be analysed in an international merger; they
do occur and do occur successfully. The goal is to do your homework on both
the company you are merging with and the country in which that company
operates.
Why do mergers fail?

It is no secret that plenty of mergers fail. Mergers may not work as

effectively as predicted. There may be many reasons behind failure of
mergers. What may appear would be beneficial has not always been proven
true. Reasons of failure are:
 Flawed intentions of executives
 Poor job of due diligence
 Globalisation
 Difference in corporate cultures.

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The major reason behind failure may be flawed intention of executives.

Executives may follow the suit when some others do it. But most CEOs get to
where they are because they want to be the biggest and the best, and many
top executives get a big bonus for merger deals, no matter what happens to
the share price later.

Globalisation, the arrival of new technological advancements or a fast-

changing financial landscape becomes a cause of failure of mergers.
Difference between corporate cultures of the merging companies acts as an
obstacle in the success of merger. A study by a global consultancy concludes
that companies focus intently on cutting costs and as a result revenues and
profits suffer. This loss of revenue momentum is one of the reasons of failure
of mergers.

It is also a fact that not all the mergers fail. Strong mergers can often squeeze
greater efficiency out of badly run rivals. The success of mergers depends
upon how realistic the deal-makers are and how well they can integrate two
companies while maintaining day-to-day operations.

Examples of mergers and acquisition in Pakistan

Year Acquiring Company Acquired Company Nature

2002 Best Way Group United Bank Limited Acquisition

Pak Arab Fertilisers

2005 Arif Habib Group Acquisition
Limited

Pak-American
2006 Azgard Nine Limited Acquisition
Fertiliser Limited

Pakistan Credit And

2007 NIB Bank Limited Merger
Investment

2008 Yousuf Sugar Mills Corporation Merger

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Examples of International Mergers and Acquisitions

Year Purchaser Purchased

1997 WORLDCOM MCI Communication

1998 BELL Atlantic GTE

1999 Vodafone AirTouch Mannesmann

AT&T Broadband &

2001 COMCAST Corp.
Internet Services

2004 JP Morgan Chase & Co Bank One Corporation

2006 AT&T Incorporation Bell South Corporation

Anheuser-Busch Companies
2008 Inbev Incorporation
Inc.

2009 Pfizer Incorporation Wyeth

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Module summary
In this module you learned:
 Simply stated, a merger is the joining of two or more companies
into a single enterprise. Acquisition refers to the acquisition of
Summary assets rather than merging the shares of two or more companies.
 Mergers can be divided into many categories like horizontal,
vertical, market extension, product extension, conglomeration
and congeneric mergers. Whereas acquisitions can be divided
into friendly and hostile acquisitions.
 Mergers are subject to various levels of regulation both from
business combination regulations in place, stock market
requirements, tax rules, and accounting changes.
 Sensible motives behind mergers are economies of scale,
economies of vertical integration, use of resources etc.
 A key item to note is that shareholders do have a vote in
accepting the merger or not. For example, in Canada a minimum
of two thirds of the voting shareholders have to approve the
merger for it to go forward.
 Mergers and acquisitions can be facilitated through the exchange
of shares, the purchase of outstanding shares for cash, or some
combination of these two payment methods.
 The method of payment that is best will differ among merger
deals and often among shareholders as not all shareholders have
the same goals and the same circumstances.
 Tax rules around mergers are often complicated and merger-
specific. Therefore, it is important to have a tax specialist on the
merger team early in the process.
 The accounting required as a result of mergers is well defined in
Canada in the Canadian Institute of Chartered Accountants
Handbook. The most difficult component in this process is often
the determination of the fair value of the target company’s net
assets.
 An increase to incremental cash flow per share is the primary
benefit of mergers and acquisitions. These increases come from
reduced costs, increased revenue, or both, or changes to working
capital. (Note that an increase in working capital by itself would
not justify a merger unless the new capital was cheaper than
alternative sources on a net basis).

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 Companies can be purchased through the exchange of cash,

shares, or some combination of the two.
 All the mergers in the world do not succeed always. Success of
mergers depends upon purity of intentions of deal makers and
working not only for cutting cost but also for enhancing
shareholders’ wealth. If these issues are ignored, mergers would
fail.
 Companies will sometimes take measures to make their company
unattractive to potential merger partners/acquirers, either because
they do not want to be taken over or because they want extra
bargaining power via poison pills, etc.
 Public companies traded on the stock exchange, can be bought
and then de-listed to become a private company.
 International mergers occur for many of the same reasons that
national mergers occur.
 International mergers have added complications of working with
regulations of more than one jurisdiction and cultural differences.

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Assignment
1. Discuss the main sources of value generated in most mergers and
acquisitions. Are all of them in the interest of society as a whole?
2. Can an acquisition that is value increasing be a bad deal for the
acquirer?
3. Why do firms like to acquire other firms?
Assignment
4. What can an executive do to resist a takeover?
5. Is it true if hostile takeovers are rare, they should not matter very
much?
6. Discuss the two main payment methods in acquisition offers?
7. Discuss the main sources of value generated in most mergers and
acquisitions. Are all of them in the interest of society as a whole?
8. Can an acquisition that is value increasing be a bad deal for the
acquirer?
9. Why do firms like to acquire other firms?
10. What can an executive do to resist a takeover?
11. Is it true if hostile takeovers are rare, they should not matter very
much?
12. Discuss the two main payment methods in acquisition offers?

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Assessment
1. Levesque Distribution Inc., a Canadian company based in Montreal,
operates a very large fleet throughout Quebec. The company has just
made a tender offer for all of the common shares of Logitex Corp., a
Toronto-based competitor. On the closing date for the tender,
Assessment Levesque’s investment banker reports that only 38 per cent of the
Logitex shares have been tendered. Levesque has no alternative to
taking up the shares that have been tendered.
a. True
b. False
2. Aviation Industries corp., a Canadian company, operates a regional
airline based in Eastern Canada. The company is in the process of
raising substantial funds for growth. It plans to acquire Westjet, and
several other carriers. In putting together its merger proposal,
Aviation Industries should consider:
a. Savings in leasing costs arising from a bigger fleet.
b. Savings in corporate head office expenses including IT.
c. Reductions in spare parts inventories.
d. A potential referral to the Competition Bureau.
e. All of the above.
3. Nebula B corp., a very widely held public company, is planning to
take over a major competitor in its industry. The target’s borrowings
are about $25 million. Expected rationalisation benefits arising from
plant closures, and a reduction in corporate overhead are expected to
be very significant. Nebula B currently has no debt and achieved a 27
per cent ROE in its latest financial year. The latest financial
statements show shareholders’ equity of $650 million. The projected
cost of the acquisitions is $120 million. Which of the following
options is likely to be the most attractive to Nebula B?
a. An offer consisting of 50 per cent common shares in Nebula
B and 50 per cent in cash.
b. An offer consisting of 25 per cent common shares plus 75 per
cent in the subordinated debentures of Nebula B.
c. A 100 per cent cash offer.
d. An offer consisting of 60 per cent common shares and 40 per
cent in the convertible debentures of Nebula B.
4. Gamma Technologies is planning to acquire a competitor, Sirens of
Titan Inc. (Sirens), based in Florida. Gamma and Sirens are

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manufacturers of medical diagnostic devices. Sirens is a private

company that is highly profitable with minimal debt. However,
reference to Sirens’ statements indicates that the company has major
outstanding lawsuits whose settlement is uncertain. Which of the
following is likely to be the most attractive option to Gamma:
a. Acquire Sirens and then hire the O.J. team to take care of the
lawsuits.
b. Proceed with the acquisition but cut the purchase
consideration to allow for the costs of settling the suits.
c. Make an all stock offer for Sirens, as that way its principals
will have to help fight the suits.
d. Purchase the key assets of Sirens such as patents and know
how.
5. Which of the following statements is not true concerning mergers of
companies:
a. Approval from the shareholders of both companies that are
party to the merger is required.
b. The shareholders of the merger parties are never subject to
taxes arising from the merger due to their ongoing interest in
the merged entity.
c. Savings from mergers generally include a reduction in
corporate head office expenses.
d. Regulatory approval is frequently required to satisfy the
provisions of the Combines Investigation Act.
6. Incredible Foods Inc. (IFI) is a privately held food processing
company. After six years of losses (totaling $35 million),
management advises stockholders that operations should cease as
losses are expected to be even larger in the coming year. A closure at
this point will provide just enough to pay off bank debt and other
creditors. All bank debt is guaranteed by major stockholders. Which
of the following options is the most attractive to IFI’s shareholders?
a. Close the doors right away.
b. Pay a $10,000 fee to a merchant banking friend to find a
purchaser of IFI.
c. Hang on for another year in case business improves.
d. None of the above.
7. Alpha and Beta Limited are the controlling shareholders (89 per cent)
of Consolidated Gravel Inc., a publicly traded company. Both Alpha
and Beta are publicly traded. The Consolidated shares are trading at a
five year low of $1.35 per share. Which of the following statements
are not true with respect to Consolidated?

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a. Taking the company private would eliminate the need for an

audit.
b. Taking the company private would eliminate the need for
independents on the board of directors.
c. The company’s net income would increase if it were taken
private.
d. The shares could be acquired by the controlling shareholder
for $1.35 or less.
8. Lysistrata Corp. is planning to make a bid for 100 per cent of the
common shares of Greek Island Adventures Inc. (GIA), a public
company. A detailed financial analysis of the company indicates that
is worth $30 - 40 million. Which of the following factors will have
the most impact on Lysistrata’s ability to successfully acquire GIA:
a. The existence of an SRP for GIA.
b. Service agreements with GIA’s president that allow for a $1
million severance package in the event of a takeover.
c. The fact that Lisa and Helen Panagopoulis between them
own 53 per cent of GIA’s shares.

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Answer Key to Review Questions

1. b – The tender offer would contain a clause providing that a minimum
percentage of shares must be tendered, usually 90%. This would allow
Levesque to avoid being forced into purchasing a minority interest in
Logitex.
2. e – All of the factors are relevant including (d). Since Air Canada has
about 80% of the domestic market it is unlikely that the Competition
Bureau would not sanction some element of rationalization by the
competition.
3. c – All of (a), (b), and (d) involve shares. Each of these offers therefore
involves sharing rationalization benefits with new shareholders. With (c),
no sharing is involved as it is a cash offer. Such an offer is feasible since
the company has no debt, is acquiring little debt from the target, and has
substantial equity.
4. d – An asset purchase is the only way to escape potentially substantial
claims from the lawsuits.
5. b – Taxes may be payable by both sets of shareholders – as they were in
the case of TCPL/Nova. It all depends on the facts of the case.
6. b – The company has a potentially sizable asset in the shape of tax losses.
Provided a purchaser can be found in the same business (not impossible
in food processing) then these losses have a value. Therefore this option
should maximize shareholder value. Option (c) is risky since bank debt is
shareholder guaranteed.
7. d – Taking Consolidated private effectively constitutes a takeover. It is
hard to imagine that no takeover premium would have to be paid to
acquire the Consolidated shares.
8. c – Lisa and Helen control GIA and therefore the bid is going nowhere
without their support. The SRP would have to be dealt with but it is of
secondary importance compared to the attitude of the control block.

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References

Brealey, R. A., Myers, S. C., Marcus, A. J., Maynes, E. M. & Mitra, D.

(2003). Fundamentals of Corporate Finance, 2nd Edition.
McGraw-Hill Ryerson.
Duff, C. (2003). Corporate Finance. Royal Roads University.
References
Gitman, L. J. (2003). Principles of Managerial Finance, 10th
Edition. Addison Wesley.
Investopedia.com
http://www.investopedia.com/terms/d/dupontidentity.asp

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