Finance Topic #6

McGraw-Hill/Irwin

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Mergers, Acquisitions, and Divestitures

Chapter 29

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Key Concepts and Skills

• Be able to define the various terms associated with M&A activity
• Understand the various reasons for mergers and whether or not those reasons are in the best interest of shareholders
• Understand the various methods for paying for an acquisition
• Understand the various defensive tactics that are available

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Chapter Outline

29.1 The Basic Forms of Acquisitions

29.2 Synergy

29.3 Sources of Synergy

29.4 Two Financial Side Effects of Acquisitions

29.5 A Cost to Stockholders from Reduction in Risk

29.6 The NPV of a Merger

29.7 Friendly versus Hostile Takeovers

29.8 Defensive Tactics

29.9 Do Mergers Add Value?

29.10 The Tax Forms of Acquisitions

29.11 Accounting for Acquisitions

29.12 Going Private and Leveraged Buyouts

29.13 Divestitures

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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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Merger versus Consolidation

• 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

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Acquisitions

• 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
• Stock acquisition
• No stockholder vote required
• Can deal directly with stockholders, even if management is unfriendly
• May be delayed if some target shareholders hold out for more money – complete absorption requires a merger
• Classifications
• Horizontal – both firms are in the same industry
• Vertical – firms are in different stages of the production process
• Conglomerate – firms are unrelated

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Varieties of Takeovers

Takeovers

Acquisition

Proxy Contest

Going Private

(LBO)

Merger

Acquisition of Stock

Acquisition of Assets

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29.2 Synergy

• Most acquisitions fail to create value for the acquirer.
• The main reason why they do not lies in failures to integrate two companies after a merger.
• Intellectual capital often walks out the door when acquisitions are not handled carefully.
• Traditionally, acquisitions deliver value when they allow for scale economies or market power, better products and services in the market, or learning from the new firms.

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Synergy

• 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 standard discounted cash flow model:

Synergy =

DCFt

(1 + R)t

S

t = 1

T

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29.3 Sources of Synergy

• Revenue Enhancement
• Cost Reduction
• Replacement of ineffective managers
• Economy of scale or scope
• Tax Gains
• Net operating losses
• Unused debt capacity
• Incremental new investment required in working capital and fixed assets

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Calculating Value

• Avoiding Mistakes
• Do not ignore market values
• Estimate only Incremental cash flows
• Use the correct discount rate
• Do not forget transactions costs

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29.4 Two Financial Side Effects of Acquisitions

• Earnings Growth
• 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 (i.e., an accounting illusion).
• Diversification
• Shareholders who wish to diversify can accomplish this at much lower cost with one phone call to their broker than can management with a takeover.

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29.5 A Cost to Stockholders from Reduction in Risk

• The Base Case
• If two all-equity firms merge, there is no transfer of synergies to bondholders, but if…
• Both Firms Have Debt
• The value of the levered shareholder’s call option falls.
• How Can Shareholders Reduce their Losses from the Coinsurance Effect?
• Retire debt pre-merger and/or increase post-merger debt usage.

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29.6 The NPV of a Merger

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

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Cash Acquisition

• The NPV of a cash acquisition is:
• NPV = (VB + ΔV) – cash cost = VB* – cash cost
• Value of the combined firm is:
• VAB = VA + (VB* – cash cost)
• Often, the entire NPV goes to the target firm.
• Remember that a zero-NPV investment may also be desirable.

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Stock Acquisition

• Value of combined firm
• VAB = VA + VB + V
• Cost of 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 do not participate in stock price appreciation with a cash acquisition
• Taxes – cash acquisitions are generally taxable
• Control – cash acquisitions do not dilute control

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29.7 Friendly vs. Hostile Takeovers

• In a friendly merger, both companies’ management are receptive.
• In a hostile merger, the acquiring firm attempts to gain control of the target without their approval.
• Tender offer
• Proxy fight

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29.8 Defensive Tactics

• Corporate charter
• Classified board (i.e., staggered elections)
• Supermajority voting requirement
• Golden parachutes
• Targeted repurchase (a.k.a. greenmail)
• Standstill agreements
• Poison pills (share rights plans)
• Leveraged buyouts

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More (Colorful) Terms

• Poison put
• Crown jewel
• White knight
• Lockup
• Shark repellent
• Bear hug
• Fair price provision
• Dual class capitalization
• Countertender offer

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29.9 Do Mergers Add Value?

• 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.

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Do Mergers Add Value?

• Shareholders of bidding firms earn a small excess return in a tender offer, but none in a straight merger:
• 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.

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29.10 The Tax Forms of Acquisition

• If it is a taxable acquisition, selling shareholders need to figure their cost basis and pay taxes on any capital gains.
• If it is not a taxable event, shareholders are deemed to have exchanged their old shares for new ones of equivalent value.

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29.11 Accounting for Acquisitions

• The Purchase Method
• Assets of the acquired firm are reported at their fair market value.
• Any excess payment above the fair market value is reported as “goodwill.”
• Historically, goodwill was amortized. Now it remains on the books until it is deemed “impaired.”

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29.12 Going Private and Leveraged Buyouts

• 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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29.13 Divestitures

• 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

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Quick Quiz

• 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 of these may be in stockholders’ best interest and which generally are not?
• What are some of the defensive tactics that firms use to thwart takeovers?
• How can a firm restructure itself? How do these methods differ in terms of ownership?