Topic: Mergers and Acquisitions

Agenda:
Mergers and Acquisitions: A Brief Overview
Rationale for Mergers
Types of Mergers
Hostile vs. Friendly Mergers
Defensive Tactics in Hostile Merger Attempts
Merger Waves
Merger Analysis
Premiums in Acquisitions
Empirical Evidence

Kyung Hwan Shim, FINS3625S2Yr2018 1

Mergers and Acquisitions: A Brief
Overview

Kyung Hwan Shim, FINS3625S2Yr2018 2

 Mergers and Acquisitions: A Brief Overview

A merger occurs when two firms combine to form a single company.

The paying company is called the acquirer (Firm A).

The selling company is called the target (Firm B).

The main motivation for mergers is the combined value is worth

more than the sum of its parts, i.e.:

> +

In capital budgeting notation:

= = − −

Kyung Hwan Shim, FINS3625S2Yr2018 3
Rationale for Mergers

Kyung Hwan Shim, FINS3625S2Yr2018 4

 Rationale For Mergers
Synergies:

• Operating economies of scales:

If the combined company has better efficiency in management,
marketing, production, or distribution
• Financial economies of scales:
If the combined firm has lower transaction costs and better analyst
coverage
• Taxes:
If the combined company pays lower taxes
• Differential efficiency:
If the management of the two standalone companies complement
each other
• Increased market power:
If competition in the product market is lower after the merger
Kyung Hwan Shim, FINS3625S2Yr2018 5
 Rationale For Mergers

Tax Considerations:

(1) To reduce corporate taxes: The combined firm has a lower total
tax burden than the sum of each firm.

(2) To avoid investor taxes: Acquisitions are alternatives to

distributions to investors which can trigger taxes.

Kyung Hwan Shim, FINS3625S2Yr2018 6

 Rationale For Mergers

Purchase of Assets Below Their Replacement Cost:

Targets with desirable assets can have market valuations (or risks)
below the cost (or risks) of acquiring those assets separately.

Very common in the tech sector.

E.g., Google acquired YouTube in 2006.

Also common in mining sector. Acquiring a firm with extensive oil

reserves cab be a lot less risky (and cost effective) than launching
exploratory/drilling projects.

Kyung Hwan Shim, FINS3625S2Yr2018 7

 Rationale For Mergers

Breakup Value:

If the breakup value exceeds the market value of a firm.

Acquirers would see such firms as quick ways to make money.

I.e., acquire the firm, spinoff its parts, and make big money.

E.g. Microsoft vs. US (1998-2004) for violation of anti-trust laws.

Kyung Hwan Shim, FINS3625S2Yr2018 8

 Rationale For Mergers
Diversification:

Conglomerate mergers occur if the acquirer and the target operate

in totally different industries.

A common justification for conglomerate mergers is shareholders

benefit from the stabilization of earnings.

A dim view on managerial behavior sees executives as the ones

who benefit from conglomerate mergers.

Conglomerate mergers may be the only way to diversify wealth for

owner-managers if they face selling constraints.

Kyung Hwan Shim, FINS3625S2Yr2018 9

 Rationale For Mergers

Managers’ Own Interests:

A bleak view on corporate control sees managers as self-serving

and value destroying.

Executives like the power and prestige that come with managing a
large firm.

Executive compensation relates to firm size independently of

performance.

Target managers may favor a friendly acquirer over a hostile

acquirer in order to keep their jobs.

Kyung Hwan Shim, FINS3625S2Yr2018 10

Types for Mergers

Kyung Hwan Shim, FINS3625S2Yr2018 11

 Types of Mergers

There are four types of mergers:

1. Horizontal: Acquirer & target are in the same line of business
(Daimler-Benz and Chrysler in ‘02)
e.g. if Pepsi merges with Coke.
2. Vertical: Acquirer & target are in a producer-supplier
relationship (Google and Motorola in ’12)
e.g. if Apple merges with Qualcomm
3. Congeneric: Acquirer & target are related but not a vertical or
horizontal merger (Prudential and Bache & Co in ‘81)
e.g. if Citigroup merges with AIG.
4. Conglomerate: Acquirer & target are unrelated enterprises (PG
and Gillette in ‘05)
e.g. if Ford merges with Sony
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Friendly and Hostile Takeovers

Kyung Hwan Shim, FINS3625S2Yr2018 13

 Hostile vs. Friendly Takeovers

Friendly Takeovers: the target manager approves the takeover.

E.g., Johnson & Johnson and Crucell in ‘11.

Process:

- The acquiring manager approaches the target manager

- Negotiates a price
- A tender offer (offer to sell shares at the proposed price) is sent
to investors
- Usually the target manager urges investors to tender their
shares.

Payment can be any combination of cash, stocks and bonds of the

acquirer.
Kyung Hwan Shim, FINS3625S2Yr2018 14
 Hostile vs. Friendly Takeovers
Hostile Takeovers: the target manager disapproves the takeover
urging shareholders not to tender their shares (e.g., Microsoft vs.
Jerry Yang of Yahoo! in ‘08).

Target managers can be defeated easily with a high all-cash offer. But
that would be very costly for the acquirer.

Takeover contest: When multiple bidders vie for the same target.

‘Pre-emptive’ or ‘blowout’ bid: a bid with a premium above the

initial bid in order to ward off other acquirers and to induce target
shareholders to accept the offer.

Many hostile takeover attempts fail.

Kyung Hwan Shim, FINS3625S2Yr2018 15

Defensive Tactics in Hostile
Takeover Attempts

Kyung Hwan Shim, FINS3625S2Yr2018 16

 Defensive Tactics in Hostile Takeover Attempts

Revisions to corporate bylaws regarding corporate control

Discouraging shareholders from tendering (e.g., Jerry Yang vs.

Microsoft on Yahoo!)

Submitting legal petitions for violation of anti-trust laws (EU Vs.

Google)

Repurchasing shares (Foster’s Group $540M buyback vs. SABMiller)

Resorting to a white knight or a white squire (Morgan Chase

acquired Bear Stearns).

Poison pills (Netflix vs. Carl Icahn’s 10% stake purchase)

Kyung Hwan Shim, FINS3625S2Yr2018 17
Merger Waves

Kyung Hwan Shim, FINS3625S2Yr2018 18

 Merger Waves

Merger activity seems to cluster around times when stock markets

perform well. Similar to IPOs and SEO waves.

Major merger waves:

Late 1800s: consolidation in ‘old fashioned’ industries (oil, steel,
tobacco)
1920s: utilities, automotive, communication industries
1960s: conglomerate mergers
1980s: LBO, and MBOs (cash acquisitions by issuing junk bonds)
Today: strategic alliances. Hostile takeovers seem less common
these days.

Food for thought: Does merger activity result in a banner stock

market performance or the other way around?
Kyung Hwan Shim, FINS3625S2Yr2018 19
Merger Analysis

Kyung Hwan Shim, FINS3625S2Yr2018 20

 Overview of Merge Analysis

Merger analysis requires finding the answer to 2 main questions:

Q) How much is the acquisition worth?
Likely to be very different from the target’s market value
Q) How much to pay?
Low bid is attractive, but likely to be rejected. High bid is
unattractive, but less likely to be contested.

Valuation approaches for mergers:

(1) Discounted cash flows: purports to determine an intrinsic value
of the synergistic gains.
(2) Market multiple analysis: assumes that the target firm is
identical to the average firm in the same industry

Kyung Hwan Shim, FINS3625S2Yr2018 21

 Adjusted Present Value (APV) Approach

In M&As, the acquirer assumes the debt of the target, and new
debt can be used to finance the acquisition.

Thus, the cost of capital and the associated effects of the capital
structure of a merger are more difficult to evaluate than a
standalone firm.

The easiest way to handle this complexity is to value the tax shields
separately from operations.

Based on M&M Prop I , the sum of the two sources of value gives
the intrinsic value.

Important: resort to Incremental CFs.

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 Adjusted Present Value (APV) Approach

Recall from Modigliani and Miller’s Proposition I:

= +

Unlevered value of the operations:

=
(1 + )

Value of tax shield from debt (textbook uses instead of ):

=
(1 + )
Target’s intrinsic firm and equity value:
= + + ,

= −
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 Adjusted Present Value (APV) Approach

Free Cash Flows each period:

= × 1 − − Δ

Tax Shields each period:

= ×

Unlevered cost of capital:

= + × (1 − ) × ( − )

× 1− × +
=
1+ × 1−
Kyung Hwan Shim, FINS3625S2Yr2018 24
 Synergic Gains: Example

Firm A intends on placing a tender off for the shares of Firm B.

Currently, Firm A has 5M shares trading at $4.16 and Firm B has
1.5M shares trading at $12. Both firms are all equity financed
and the cost of capital are 12.5% and 11.5% respectively.

Pre-merger firm values:

= × =5 × $4.16 = $20.80

= × = 1.5 × $12 = $18

Kyung Hwan Shim, FINS3625S2Yr2018 25

 Synergic Gains: Example

The merger will consolidate fixed assets in order to improve

economies of scale. Production capacity will increase from 4M unit
of output to 10M, while fixed cost will increase from $20M to $40M
per year. There will be a minor decrease in variable costs from $6 to
$5.5 per unit of output. The corporate tax rate is 35%.

The increase in output quantity means that there will be a decrease

in the sale price from $12 to $10.5 per unit of output.

A one-time reorganization cost of $2M and a one-time decrease in

inventory requirement of $0.5M will result from the merger.

What is the value of the Kyung

synergic gains from the merger?
Hwan Shim, FINS3625S2Yr2018 26
 Synergic Gains: Example

× 1− = × − − × 1−
= [10 × $10.5 − $5.5 − $40 ] × 1 − .35
= $6.5
× 1− = × − − × 1−
= [4 × $12 − $6 − $20 ] × 1 − .35 = $2.6

Δ × 1− = $6.5 − $2.6 = $3.90

$3.90
− = + 0.5 −2 = $32.413
0.115

= − − = $32.413 − $18
= $14.413043
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Premiums in Acquisitions

Kyung Hwan Shim, FINS3625S2Yr2018 28

 Premiums in Tender Offers

Premium: The cost of an acquisition in excess of the target’s value.

Premium in a Cash Bid:

= −
=( − ′) + ( ′− )

Gains from Merger (net of acquisition costs):

= − − =
− − − = −

If > 0, then there are synergistic gains in the acquisition

Conditional on > 0, if ≥ then the target

shareholders get all the economic gains
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 Cash Premium in Tender Offers: Example

Firm B shares experienced a sudden jump of 20% following rumors

of a takeover. Firm A decides to make an immediate cash offer of
$15.5 for Firm B’s shares before further rises in share price.

How much was the cash bid premium? If the target shareholders
tender their shares will the acquiring shareholders see a profit?

= − ′ + ′−
= 1.5 × 15.5 − 14.4 + 1.5 × 14.4 − 12
= $1.65 + $3.6 = $5.25

= $14.413043 > = $5.25

The takeover will be profitable for the shareholders of Firm A if the

bid is accepted.
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 Cash Premium in Tender Offers: Example

The bid was not successful. Not a single shareholder of Firm B

tendered their shares.

The management of Firm A came to the conclusion that the cash

bid was too low considering the synergic gains of the merger.

If the shareholders of Firm B hold out, what is the highest cash bid
that Firm A should consider such that the stock holders would
benefit from the merger?

> =( ∗
− )×

$14.413043 >( ∗ − $12) × 1.5

∗ < $21.6087
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 Premium in Stock Tender Offers

Premium in Stock Bids:

: post merger number of shares of the new firm

: number of shares of the new firm exchanged for target’s shares
in the bid.
=

= × − =( × − ′) + ( ′− )

If >0, then there are economic gains from an acquisition

If ≥ > 0, then all the economic gains go to the

target shareholders.
Kyung Hwan Shim, FINS3625S2Yr2018 32
 Premium in Stock Tender Offers: Example

The management of Firm A offers to exchange the shares of the

target for the shares of the post-merged firm with the offer of a
2.1666-for-1 stock swap deal. There will be in total 6.5M shares
outstanding of the post-merged firm.

What is the premium in the stock bid? If Firm B shareholders

tender their shares in the bid, will the shareholders of Firm A
profit?

Kyung Hwan Shim, FINS3625S2Yr2018 33

 Premium in Stock Tender Offers: Example

= − + = $32.413 + $20.80 = $53.213

$53.213
= = = $8.19
6.5

=( × − ′) + ( ′ − )
= ($8.19 × 3.25 − 21.60 ) + (21.60 − 18 )
= $5.0175M + $3.6M = $8.60652M

= $14.413043 > $8.60652 =

The takeover will be profitable for the shareholders of Firm A if the

bid is accepted.

Kyung Hwan Shim, FINS3625S2Yr2018 34

 Premium in Stock Tender Offers: Example
The bid was not successful. Not a single shareholder of Firm B
tendered their shares.

The management of Firm A came to the conclusion that the stock bid
was too low considering the synergic gains of the merger.

If the shareholders of Firm B hold out, what is the highest stock bid
that Firm A should consider such that the stock holders would benefit
from the merger?
>
$14.413043 > × ∗−
∗
< 3.9593

.
I.e., at most = 2.6395-for-1 stock swap.
.
Kyung Hwan Shim, FINS3625S2Yr2018 35
Empirical Evidence

Kyung Hwan Shim, FINS3625S2Yr2018 36

 Empirical Evidence: Are there Gains and
Who Captures the Gains ?
Announcements of takeovers are associated with an average share price
rise of:

30% for the target if takeover is hostile

20% for the target if takeover is friendly

Share prices of acquiring firms, on average, stay constant.

The empirical results are consistent with the notion that mergers, on
average, create synergistic gains;

but the gains are captured by the target shareholders;

and that investors are rational about the synergistic gains.

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 Conclusion

Mergers and acquisitions are assessed similarly to projects;

Except the cost of the acquisition is variable.

A major challenge is to ensure that the premium paid for the

acquisition does not exceed the value of the synergistic gains,

otherwise, the acquisition destroys acquirer shareholders’ wealth.

Often times mergers have positive merit but ones initiated by self-
servings managers are perverse and destroy firm value.

Questions: 26-1 to 26-4

Problems: 26-1 to 26-3
Kyung Hwan Shim, FINS3625S2Yr2018 38