OM FINAL

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

CHAPTER TEN: MERGERS AND ACQUISITIONS

Yi Zhou

Associate Professor Department of Finance

College of Business San Francisco State University

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

DEFINITIONS POISON PILL TYPES MOTIVES

DEFINITIONS

Consolidation: A + B → C. Acquisition: X + Y → New Firm X. Target: the company being acquired. Acquirer: the company acquiring the target.

Friendly takeover: when the target company board of directors endorses a takeover offer. Offer made through the target’s board of directors.

Hostile takeover: when the target company board of directors objects to a takeover offer. Offer made directly to target shareholders. 1) Bear hug: Informal offer made directly to the target shareholders. 2) Tender offer: Formal offer made directly to the target shareholders. 3) Poison pill: Share dilution.

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

DEFINITIONS POISON PILL TYPES MOTIVES

POISON PILL

A poison pill is created when a board allows some shareholders to purchase a great deal of newly–issued stock very cheaply in the event that anyone buys a block of shares without managers’ prior approval. Once triggered, the bidder’s shares are drastically diluted

Thus, no acquirer has ever intentionally triggered a poison pill and, as long as the pill is in place, it is an insurmountable defense against takeover.

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

DEFINITIONS POISON PILL TYPES MOTIVES

TYPES

Horizontal Merger: Companies are in the same line of business (competitors). Walter Disney Company buys Lucasfilm for $4 billion in October 2012.

Vertical Merger: Companies are in the same line of production (supplier–customer). Google acquired Motorola Mobility Holdings for $12.5 billion in June 2012.

Conglomerate Merger: Companies are in unrelated line of business. Warren Buffett’s Berkshire Hathaway Inc. acquires Lubrizol (chemical maker) for $9 billion in 2011.

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

DEFINITIONS POISON PILL TYPES MOTIVES

MOTIVES

Synergy. Economies of scale.

Growth. External growth.

Increasing market power. Horizontal or vertical integration to increase strength in the industry.

Acquiring unique capabilities or resources. Resources include patents, technology, trademarks, or raw materials.

Unlocking hidden value. Improve management, reorganize structure, breakups, or liquidations.

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

METHOD 1: BID EVALUATION METHOD 2: COMPARABLE COMPANY ANALYSIS

METHOD 1: BID EVALUATION

Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid was made public was $15 per share. Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%. What are the synergistic gains from this merger? What parties, if any, share in these gains? What is the estimated value of the Big Company post-merger?

Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. Price paid for the Target = $18 million.

The value of Little Company stock before the bid was made public was $15 per share. Pre-merger value of the Target = $15 million.

Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Pre-merger value of the Acquirer = $40 × 10 = $400 million. Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%. Synergistic gains S = $2 million/10% = $20 million.

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

METHOD 1: BID EVALUATION METHOD 2: COMPARABLE COMPANY ANALYSIS

SOLUTIONS

Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid was made public was $15 per share. Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%. What are the synergistic gains from this merger? What parties, if any, share in these gains? What is the estimated value of the Big Company post-merger?

Synergistic gains S = $2 million/10% = $20 million.

Target’s gain = Premium = Price paid for the Target − Pre-merger value of the Target = $18 million − $15 million = $3 million. (3/20 = 15% of the synergistic gains.) Acquirer’s gain = Synergistic gains − Premium = $20 million − 3 million = $17 million. (17/20 = 85% of the synergistic gains.)

Post-merger value of the Acquirer = Pre-merger value of the Acquirer + Acquirer’s gain = $400 million + $17 million = $417 million.

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

METHOD 1: BID EVALUATION METHOD 2: COMPARABLE COMPANY ANALYSIS

METHOD 2: COMPARABLE COMPANY ANALYSIS

Using the comparable company analysis, if the takeover premium is 20%, what is the XYZ Company’s value in a merger?

XYZ Company Average of Comparables Earnings (E) $10 million P/E of comparables 30 times

Cash flow (CF) $12 million P/CF of comparables 25 times Book equity (BV) $50 million P/BV of comparables 2 times

Sales (S) $100 million P/S of comparables 2.5 times

Answer : = (E × P/E + CF × P/CF + BV × P/BV + S × P/S)/4 (1) = (10 × 30 + 12 × 25 + 50 × 2 + 100 × 2.5)/4 = (300 + 300 + 100 + 250)/4 = 237.50

Estimated takeover price: 237.50 × (1 + 20%) = 285.00.

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

HHI

HHI

The Herfindalhl–Hirschman Index (HHI) is a measure of concentration within an industry and is often used by regulators to evaluate the effects of a merger.

Post-Merge HHI Concentration Government Action Less than 1,000 Not concentrated No action

Between 1,000 and 1,800 Moderately concentrated Possible challenge More than 1,800 Highly concentrated Challenge

Company Mkt Shr. HHI Before Company Mkt Shr. HHI After A 15% 225 A 15% 225 B 15% 225 B 15% 225 C 15% 225 C 15% 225 D 15% 225 D+E 30% 900 E 15% 225

1125 1575

The industry would be considered moderately concentrated after the combination of E and F,

which may result in a government challenge.

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS

TYPES AND MOTIVES MERGERS AND ACQUISITIONS’ EVALUATION

HERFINDAHL-HIRSCHMAN INDEX (HHI) WHO BENEFITS FROM MERGERS

WHO BENEFITS FROM MERGERS

WHO BENEFITS FROM MERGERS

Mergers create value for the target company shareholders in the short run.

Acquirers tend to overpay in merger bids. The transfer of wealth is from acquirer to target company shareholders. Roll: Overpayment results from “hubris."

Acquirers tend to underperform in the long run. They are unable to fully capture any synergies or other benefit from the merger.

YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS