Mergers and Acquisitions

Basic terms and definitions concerning

mergers and acquisitions
Reasons for mergers and acquisitions
Real world empirical observations
An example of valuing a potential acquisition

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Mergers and Acquisitions

Merger: One firm absorbs the assets and liabilities of
the other firm in a merger. The acquiring firm retains
its identity. In many cases, control is shared between
the two management teams. Transactions were

generally conducted on friendly terms.

In a consolidation, an entirely new firm is created.
Mergers must comply with applicable state laws. Usually,

shareholders must approve the merger by a vote.

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Mergers and Acquisitions

Acquisition: Traditionally, the term described a
situation when a larger corporation purchases the
assets or stock of a smaller corporation, while control
remained exclusively with the larger corporation.
Often a tender offer is made to the target firm (friendly) or

directly to the shareholders (often a hostile takeover).

Transactions that bypass the management are considered
hostile, as the target firms managers are generally opposed
to the deal.
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Mergers and Acquisitions

In reality, there is always a bidder and a target. Almost all

transactions could be classified as acquisitions. Some modern

finance textbooks use the two terms interchangeably.
Divestiture: a transaction in which a firm sells one of its
subsidiaries or divisions to another firm.
Spin-off: a transaction in which a firm either sells or issues all
or part of its subsidiaries to its existing public investors, by
issuing public equity. In 1997 PepsiCo spun-off its restaurant
division. Shareholders received one share of the new restaurant
company (TRICON), for every 10 issues of Pepsi they held.
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Mergers and Acquisitions

Target: the corporation being purchased, when there is
a clear buyer and seller.
Bidder: The corporation that makes the purchase,
when there is a clear buyer and seller. Also known as

the acquiring firm.

Friendly: The transaction takes place with the
approval of each firms management
Hostile: The transaction is not approved by the
management of the target firm.
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Mergers and Acquisitions

Reasons for mergers & acquisitions:
Strategic: The combined FCFs (Free Cash Flows)
of the merged operation are greater than the sum of
the individual cash flows.
Financial: The cash flows and also the market value
of the target are below their true value, due to
perhaps inefficient management. Such firms are

typically restructured after the acquisition.

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Mergers and Acquisitions

Reasons for mergers & acquisitions (continued):
Diversification: Dont put all your eggs in one basket.

Current finance literature seriously questions the merits of

this reasoning: Why does the management know better than
the shareholders how to achieve diversification?
It is usually the case that shareholders can diversify much
more easily than can a corporation.
Individuals can easily diversify by buying shares in mutual
funds.

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Mergers and Acquisitions

Reasons given for divestitures and spin-offs:
To undo non-profitable mergers (originally motivated by

pure diversification)
To break up a inefficiently run conglomerate
In the case of spin-offs, to improve managerial efficiency in
the subsidiary, by offering a directly observable stock price
as an (admittedly imperfect) measure of managerial
performance.
Also, in the case of spin-offs, to give equity investors more
flexibility in diversifying their investment portfolios.

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Mergers and Acquisitions

Calculate the incremental financial Free Cash Flows
(FCFs) resulting from either:
synergies (increased market power, reduced costs, etc.)
better management discipline

Calculate the total Free Cash Flows of the merged

corporation (M), by adding together the incremental
cash flows, the old cash flows of the target (T), and
the old cash flows of the bidder (B):
FCF(M) = FCF(T) + FCF(B) + FCF(M)
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Mergers and Acquisitions

Discount FCF(M) at the cost of capital or WACC of
the new corporation
Obtain the present value of the new corporation V(M).
If V(M) > V(T) + V(B) then proceed with the merger.

How much should the bidder pay for the target?

At least V(T). In this case the bidder shareholders keep most

benefits from merger.

At most V(M)-V(B). Here benefits accrue to target
shareholders.
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Mergers and Acquisitions

The evidence suggests that bidders generally

realize zero NPV on their M&A transactions.

In contrast, target shareholders appear to realize
most (if not all) of the benefits resulting from
the M&A transaction.

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Mergers and Acquisitions

In efficient markets, the stock market reaction on the day of the

merger announcement represents the NPV of the transaction.

Generally, bidder stock prices remain unchanged or even drop
when an acquisition is announced. Historically bidding firm
stock prices fall more often than increase.
Target stock prices, however, increase by 20% to 40% on the
announcement day.
A good example is the market reaction to the Exxon/Mobil
merger.

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Mergers and Acquisitions

Target stock prices, however, increase by 20%

to 40% on the announcement day.

A good example is the market reaction to the
Exxon/Mobil merger.

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Mergers and Acquisitions

Cumulative Abnomal Returns around Merger
Announcement
20.00%

CAR (%)

15.00%
10.00%

EXXON
MOBIL

5.00%
0.00%
-5 -4 -3

-2 -1

-5.00%
Day relative to announcement day

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Example of merger valuation

We will assume an acquisition of one mature firm by another:

Firm A acquires Firm B. Recall that PV0=CF1/(r-g). Assume
here that market equals intrinsic value.
Firm A: expected FCF1=$1000M, wacc=10%, g=6%, and
500M shares of common stock exist. We estimate its current
(t=0) (stand-alone) value.

VA=FCF1/(wacc g) = 1000M/(0.10 0.06) = $25,000M ($25 billion) or

25,000M/500M = $50.00 per share.

Firm B: expected FCF1=$75M, wacc=12%, g=6%, and 100M

shares of common stock exist. We estimate its current (t=0)
(stand-alone) value.

VB=FCF1/(wacc g) = 75M/(0.12 0.06) = $1250M ($1.25 billion) or

1250M/100M = $12.50 per share.
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Example of merger valuation,

continued

A combined Firm AB will generate a Free Cash

Flow of FCF1=$1130M next year (t=1).
Calculate the incremental or FCFAB.

FCFAB = FCFAB [FCFA + FCFB]

FCFAB = 1130M [1000M + 75M] = $55M

The combined Firm AB will produce $55M

more FCF next year than the sum of what the
stand-alone firms A and B can do on their on.
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Example of merger valuation,

continued

What will be the Weighted Average Cost of Capital

or WACC of the combined Firm AB.
Lets assume that A and B contribute proportionally
(here, weighted by existing intrinsic values VA and VB)
to the new WACCAB.

WACCAB = [VA/(VA+VB)](WACCA) +
[VB/(VA+VB)](WACCB)
WACCAB = [25,000/(25,000+1250)](0.10) +
[1250/(25,000+1250)](0.12) = 0.100952 or 10.0952%
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Example of merger valuation,

continued

What is the proposed Firm AB worth? What price should Firm

A pay? First, estimate the value of the combined Firm AB.
Assume the FCF growth rate remains at g=6% per year.

VAB=FCFAB/(waccAB g) = 1130M/(0.10092 0.06) = $27,593.28M

Vsynergy = VAB (VA + VB) = 27593.28M (25,000M + 1250M) =
$1343.04M

The merged Firm AB is worth $27,593.28M, which is

$1343.04M more than the firms are worth as stand-alone firms.
Also the synergy or NPV of this merger is $1343.04M. This
merger makes economic sense.
However, at what price will Firm A be able to acquire Firm B?
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Example of merger valuation,

continued

Scenario 1: What if Firm A pays a price that allocates

all of the Vsynergy or merger NPV to the existing Firm A
shareholders? The entire merger synergy or NPV will
become impounded into the Firm A shares.

This involves paying $1250M or $12.50 per share for all the
existing Firm B shares. Basically, Firm B shareholders are
selling at the existing Firm B stock price of $12.50 per share!
New Firm A value = (VA + Vsynergy)/500M shares or
(25,000M + 1342.04M)/500M = $52.69 per share
Firm B shareholders are unlikely to approve such an offer.
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Example of merger valuation,

continued

Scenario 2: What if Firm A pays a price that allocates

all of the merger NPV or Vsynergy to the existing Firm B
shareholders?
This involves paying VB + Vsynergy = 1250M +
1343.04M = $2593.04M or $2593.04M/100M =
$25.93 per share for all the existing Firm B shares.
Firm B shareholders are very likely to approve such an
offer.
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Example of merger valuation,

continued

Scenarios 1 and 2 represent what appear to be extremes of

bidding on a target firm.

Scenario 1, paying the existing $12.50 per share for Firm B, gives Firm
A shareholders all of the merger NPV or Vsynergy.
Scenario 2, paying $25.93 per share (an almost 100% premium) for Firm
B, gives Firm B shareholders all of the merger NPV or Vsynergy. Firm A
shareholders would receive no benefit.

Ideally, the rational price would be one that allocates the merger
NPV somewhat proportionally between the bidder and target
firm shareholders.
However, if history is any indicator, an price similar to scenario
2 (or even more) is the more likely outcome!
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