corporate finance

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SESSION 7: MERGERS AND ACQUISITIONS

P R O F . J U L I A S O K O L O V A

BCO315 CORPORATE FINANCE

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• Discuss the different types of mergers and acquisitions, why they should (or shouldn’t) take place, and the terminology associated with them

• Describe how accountants construct the combined balance sheet of the new company

• Define the gains from a merger or acquisition and how to value the transaction

KEY CONCEPTS AND SKILLS

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• The Legal Forms of Acquisitions • Accounting for Acquisitions • The Cost of an Acquisition • Gains from Acquisitions • Financial Side Effects of Acquisitions • Evidence on Acquisitions • Divestitures and Restructurings

SESSION OUTLINE

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• There are three basic legal procedures that one firm can use to acquire another firm: 1. Merger or consolidation 2. Acquisition of stock 3. Acquisition of assets

• Although these forms are different from a legal standpoint, the financial press frequently does not distinguish between them.  The term merger is often used regardless of the actual

form of the acquisition.

THE LEGAL FORMS OF ACQUISITIONS

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• The Bidder – the acquiring firm

• The Target Firm – the acquired firm

• The Consideration – cash or stock offered to the target firm by the bidder in the acquisition

MERGER TERMS

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• 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.

MERGER VS. CONSOLIDATION

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• 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 made directly by the bidder to target firm shareholders  Those shareholders who choose to accept the offer

tender their shares by exchanging them for cash or securities (or both), depending on the offer.  A tender offer is frequently contingent on the bidder’s

obtaining some percentage of the total voting shares.  If not enough shares are tendered, then the offer

might be withdrawn or reformulated.

ACQUISITION OF STOCK

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• Stock acquisition versus a merger  No stockholder vote required with stock acquisition  Can deal directly with stockholders in a stock acquisition,

even if management is unfriendly  Resistance by the target firm’s management often makes

the cost of acquisition by stock higher than the cost of a merger.

 Often, a significant minority of shareholders will hold out in a tender offer, which will usually increase the cost and time required for a merger.

 Complete absorption of one firm by another requires a merger.  Many acquisitions by stock are followed up with a formal

merger later.

ACQUISITION OF STOCK (CTD.)

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• A firm can acquire another firm by buying most or all of its assets.

• In this case, the target firm still exists unless the stockholders choose to dissolve it.

• This type of acquisition requires a formal vote of the shareholders of the selling firm.

• One advantage of an asset acquisition is that there is no problem with minority shareholders holding out.

• One disadvantage of an acquisition of assets may involve transferring titles to individual assets, which can be very costly.

ACQUISITION OF ASSETS

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• Three types of acquisitions according to financial analysts:

 Horizontal – both firms are in the same industry

 Vertical – firms are in different stages of the production process

 Conglomerate – firms are unrelated

CLASSIFICATIONS OF ACQUISITIONS

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• Takeover - control of a firm transfers from one group to another

• Possible forms of a takeover: 1. Acquisition

• Merger or consolidation • Acquisition of stock • Acquisition of assets

2. Proxy contest - an attempt to gain control of a firm by soliciting a sufficient number of stockholder votes to replace existing management

3. Going private - transactions in which all publicly owned stock in a firm is replaced with complete equity ownership by a private group

TAKEOVERS

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• Leveraged buyouts (LBOs): going-private transactions in which a large percentage of the money used to buy the stock is borrowed  Often, incumbent management is involved

 Such transactions are also termed management buyouts (MBOs) when existing management is heavily involved.

GOING PRIVATE

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• Strategic alliance: agreement between firms to cooperate in pursuit of a joint goal

• Joint venture: typically an agreement between firms to create a separate, co- owned entity established to pursue a joint goal

ALTERNATIVES TO MERGER

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• Since 2001, the Federal Accounting Standards Board (FASB) requires that all acquisitions should be treated under the purchase accounting method.

• 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

ACCOUNTING FOR ACQUISITIONS

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• Method 1: CASH ACQUISITION  The cost of an acquisition when cash is used is

just the cash itself.  The cash cost largely determines whether the

merger will be able to create value.

• Method 2: STOCK ACQUISITION  In a stock merger, no cash actually changes

hands.  Instead, the shareholders of the target firm come

in as new shareholders in the merged firm.

COST OF AN ACQUISITION

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• Cost of Stock 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

CASH VS. STOCK ACQUISITION

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• There are a number of possible reasons why a target firm will somehow be worth more in our hands than it is worth now.

• To determine the gains from an acquisition, we need to first identify the relevant incremental cash flows, or, more generally, the source of value.

GAINS FROM ACQUISITIONS

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• Synergy is the positive incremental net gain associated with the combination of two firms through a merger or acquisition.

• Synergy is generally a good reason for a merger.

• Firms must examine whether the synergies create enough benefit to justify the cost.

SYNERGY

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• The incremental cash flow, ΔCF, can be broken down into four parts:

ΔCF = ΔRevenue – ΔCost – ΔTax – ΔCapital requirements

• The merger will make sense only if one or more of these cash flow components are beneficially affected by the merger.

• The possible cash flow benefits of mergers and acquisitions fall into four basic categories: Revenue enhancement, cost reductions, lower taxes, and reductions in capital needs.

POTENTIAL SOURCES OF SYNERGY

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• Marketing gains  Improving advertising  Improving the distribution network  Improving an unbalanced product mix

• New strategic benefits

• Increasing market power

SOURCE OF SYNERGY : REVENUE ENHANCEMENT

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• 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

SOURCE OF SYNERGY: COST REDUCTIONS

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Tax gains are a powerful incentive for some acquisitions. The possible tax gains from an acquisition include the following:

1. The use of tax losses. 2. The use of unused debt capacity. 3. The use of surplus funds. 4. The ability to write up the value of

depreciable assets.

SOURCE OF SYNERGY: LOWER TAXES

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• 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).

SOURCE OF SYNERGY: REDUCTIONS IN CAPITAL NEEDS

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• 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.

• Be aware of transaction costs – these can add up quickly and become a substantial cash outflow.

AVOIDING MISTAKES

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• Some firms could see a value increase with a change in management.

• These are firms that are poorly run or otherwise do not efficiently use their assets to create shareholder value.

• Mergers are a means of replacing management in such cases.

INEFFICIENT MANAGEMENT

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• Financial side effects of a merger may occur regardless of whether the merger makes economic sense or not.

• Two such possible effects:  EPS growth  Diversification

FINANCIAL SIDE EFFECTS OF ACQUISITIONS

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• 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.

EPS GROWTH

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• 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.

DIVERSIFICATION

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• 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.

EVIDENCE ON ACQUISITIONS

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• 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

DIVESTITURES AND RESTRUCTURINGS

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• 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?

• How can a firm restructure itself? How do these methods differ in terms of ownership?

QUICK QUIZ

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• 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 change in overall firm value from the merger?

 What is the value of the target firm to the bidding firm?

COMPREHENSIVE PROBLEM

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• The merger creates synergy since the combined firm cash flow is greater than the sum of the individual firm cash flows.

• The change in value is $2 million / 0.12 = 16.67 million

• Value of the target firm to the bidding firm is the current value of $167 million ($20 million / 0.12) plus the change in value of 16.67 million = $184 million

COMPREHENSIVE PROBLEM: SOLUTION

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RECOMMENDED READING:

• ROSS, Fundamentals of Corporate Finance, 12e, McGrawHill. Chapter 26 MERGERS AND AQUISITIONS

• Websites:  https://www.investopedia.com/  Bloomberg Markets: www.bloomberg.com  CNN Money: money.cnn.com  Yahoo Finance: finance.yahoo.com