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CHAPTER

29
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Mergers and Acquisitions

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Chapter Outline
29.1 The Basic Forms of Acquisitions 29.2 The Tax Forms of Acquisitions 29.3 Accounting for Acquisitions 29.4 Determining the Synergy from an Acquisition 29.5 Source of Synergy from Acquisitions 29.6 Calculating the Value of the Firm after an Acquisition 29.8 Two "Bad" Reasons for Mergers 29.9 The NPV of a Merger 29.10 Defensive Tactics
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29.1 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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29.1 The Basic Forms of Acquisitions

Merger or Consolidation
A merger refers to the absorption of one firm by another firm. Acquiring firm retains its own name and identity. Acquires all of assets and liabilities of the acquired firm. The acquired firm ceases to exist as separate entity. A consolidation is the same as a merger except that an entirely new firm is created.
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29.1 The Basic Forms of Acquisitions

Advantages and disadvantages of Merger to acquire a firm
A merger is straight forward Does not cost much like other forms Avoid transferring the title of assets and liabilities. A merger must be approved by a vote of the stockholder.

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29.1 The Basic Forms of Acquisitions

Acquisition of Stock
Acquire another firms voting stock in exchange for cash, shares of stock or other securities. A private offer is taken directly to the selling firms stockholders by another firm.. This can be accomplished by use of tender offer.
A tender offer is a public offer to buy shares of target firm.

It is made by one firm directly to the shareholders of another firm.

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29.1 The Basic Forms of Acquisitions

Acquisition of Assets
One firm can acquire another firm by buying all of its assets. A formal vote of the shareholders of selling firm is required. Transfers title to assets which is costly.

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Classification of acquisitions
Horizontal Acquisition
Acquisition of firm in the same industry

Vertical Acquisition
Acquisition involves firms at different steps of the productions process.

Conglomerate Acquisition
Both firms are not related to each other.

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Varieties of Takeovers
Merger Acquisition Acquisition of Stock Acquisition of Assets

Takeovers

Proxy Contest Going Private Transaction

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Varieties of Takeovers
Takeover can occurs by
Acquisition
If takeover is achieved by acquisition, it will be by merger, tender offer for shares of stock or purchase of assets.

Proxy contest
A group of shareholders gain control on the board of directors by voting in new directors

Going private transactions

All equity shares of a public firm are purchased by a small group of investors.
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29.2 The Tax Forms of Acquisitions

If it is a taxable acquisition, selling shareholders need to figure their cost basis and pay taxes on any capital gains. If it is tax free event, shareholders are deemed to have exchanged their old shares for new ones of equivalent value.

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29.3 Accounting for Acquisitions

The Purchase Method
The assets of acquired firm be reported at their fair market value on the books of the acquiring firm. In a purchase, an accounting term called is created .
Goodwill is the excess of the purchase price over the sum of the fair market values of the individual assets required.

Purchase accounting is generally used under other financing arrangements.

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29.4 Determining the Synergy from an Acquisition

Suppose firm A is contemplating acquiring firm B. The synergy from the acquisition is Synergy = VAB (VA + VB) The synergy of an acquisition can be determined from the usual discounted cash flow model: Synergy = where
DCFt = DRevt DCostst DTaxest DCapital Requirementst
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S
T t=1

DCFt

(1 + r)t

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29.5 Source of Synergy from Acquisitions

Revenue Enhancement
Combined firm may generate greater revenue than separate firms. Increased revenue may come from
Marketing gains Strategic benefits Market or monopoly power

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29.5 Source of Synergy from Acquisitions

Cost Reduction
Combined firm my operate more efficiently and lower the cost.
Economies of scale
Average cost of production falls while level of production increases.

Economies of vertical integration Complementary Resources Elimination of inefficient management

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29.5 Source of Synergy from Acquisitions

Tax Gains
Net Operating Losses
Combined firms pay lower taxes than they remain separate

Unused Debt Capacity

Financial distress cost is likely to be less for combined firm than that of two separate. Increase debt-equity ratio which creates tax benefits

Surplus fund

The cost of capital

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29.8 Two "Bad" Reasons for Mergers

Earnings Growth
An acquisition can create the appearance of earnings growth which may fool investors. The merger may not create additional value If the market is smart, it will realize that the combined firm is worth the sum of the value of separate firm before merger If the market is fooled it might mistake the increase of earnings growth. Only an accounting illusion.
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29.8 Two "Bad" Reasons for Mergers

Diversification
Diversification through merger may not benefit shareholders. Diversification can produce gain s to the acquiring firm only
Diversification decrease the unsystematic variability Diversification reduce the risk and increase debt capacity

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29.9 The NPV of a Merger

Typically, a firm would use NPV analysis when making acquisitions. The analysis is straightforward with a cash offer, but gets complicated when the consideration is stock.

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The NPV of a Merger: Cash

NPV of merger to acquirer =
Synergy Premium Synergy = VAB (VA + VB) Premium = Price paid for B VB NPV of merger to acquirer = Synergy Premium

= [VAB (VA + VB)] [Price paid for B VB] = VAB (VA + VB) Price paid for B + VB = VAB VA Price paid for B
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The NPV of a Merger: Common Stock

The analysis gets muddied up because we need to consider the post-merger value of those shares were giving away.
Target firm payout a New firm value
New shares issued a= Old shares + New shares issued
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Cash versus Common Stock

Overvaluation
If the target firm shares are too pricey to buy with cash, then go with stock.

Taxes
Cash acquisitions usually trigger taxes. Stock acquisitions are usually tax-free.

Sharing Gains from the Merger

With a cash transaction, the target firm shareholders are not entitled to any downstream synergies.
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29.10 Defensive Tactics

Target-firm managers frequently resist takeover attempts. It can start with press releases and mailings to shareholders that present managements viewpoint and escalate to legal action. Management resistance may represent the pursuit of self interest at the expense of shareholders. Resistance may benefit shareholders in the end if it results in a higher offer premium from the bidding firm or another bidder.
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Divestitures
The basic idea is to reduce the potential diversification discount associated with commingled operations and to increase corporate focus, Divestiture can take three forms:
Sale of assets: usually for cash Spinoff: parent company distributes shares of a subsidiary to shareholders. Shareholders wind up owning shares in two firms. Sometimes this is done with a public IPO. Issuance if tracking stock: a class of common stock whose value is connected to the performance of a particular segment of the parent company.
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The Corporate Charter

The corporate charter establishes the conditions that allow a takeover. Target firms frequently amend corporate charters to make acquisitions more difficult. Examples
Staggering the terms of the board of directors. Requiring a supermajority shareholder approval of an acquisition
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Repurchase Standstill Agreements

In a targeted repurchase the firm buys back its own stock from a potential acquirer, often at a premium. Critics of such payments label them greenmail. Standstill agreements are contracts where the bidding firm agrees to limit its holdings of another firm.
These usually leads to cessation of takeover attempts. When the market decides that the target is out of play, the stock price falls.

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Exclusionary Self-Tenders
The opposite of a targeted repurchase. The target firm makes a tender offer for its own stock while excluding targeted shareholders.

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Going Private and LBOs

If the existing management buys the firm from the shareholders and takes it private. If 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 pervious managers into owners. This reduces the agency costs of equity
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Other Devices and the Jargon of Corporate Takeovers

Golden parachutes are compensation to outgoing target firm management. Crown jewels are the major assets of the target. If the target firm management is desperate enough, they will sell off the crown jewels. Poison pills are measures of true desperation to make the firm unattractive to bidders. They reduce shareholder wealth.
One example of a poison pill is giving the shareholders in a target firm the right to buy shares in the merged firm at a bargain price, contingent on another firm acquiring control.
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