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Chapter

19

Mergers and Acquisitions

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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
19.1 The Legal Forms of Acquisitions
19.2 Taxes and Acquisitions
19.3 Accounting for Acquisitions
19.4 Gains from Acquisition
19.5 Some Financial Side Effects of Acquisitions
19.6 The Cost of an Acquisition
19.7 Defensive Tactics
19.8 Some Evidence on Acquisitions: Does M&A Pay?
19.9 Divestitures and Restructurings
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19.1 The Legal 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 firms 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
Merger

Takeovers

Acquisition

Acquisition of Stock

Proxy Contest

Acquisition of Assets

Going Private
(LBO)

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19.2 Taxes and Acquisitions

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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19.3 Accounting for Acquisitions

The Purchase Method

Pooling of Interests

The source of much goodwill


Pooling of interest is generally used when the
acquiring firm issues voting stock in exchange for at
least 90 percent of the outstanding voting stock of
the acquired firm.

Purchase accounting is generally used under


other financing arrangements.

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19.4 Gains from Acquisition

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 aren't 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 =

t=1

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CFt
(1 + r)t

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Sources of Synergy

Revenue Enhancement
Cost Reduction

Tax Gains

Replacement of ineffective managers


Economies of scale or scope
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
Dont forget transactions costs

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19.5 Some Financial Side Effects

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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19.6 The Cost of an Acquisition

Typically, a firm would use NPV analysis


when making acquisitions.
The analysis is straightforward with a cash
offer, but gets complicated when the
consideration is stock.

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Cash Acquisition

The NPV of a cash acquisition is:

NPV = (VB + V) 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

Cost of acquisition

VAB = VA + VB + V

Depends on the number of shares given to the target


stockholders
Depends on the price of the combined firms stock after the
merger

Considerations when choosing between cash and stock

Sharing gains target stockholders dont 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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19.7 Defensive Tactics

Corporate charter
Establishes conditions that allow for a takeover
Supermajority voting requirement

Targeted repurchase (a.k.a. greenmail)


Standstill agreements
Poison pills (share rights plans)
Leveraged buyouts

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More (Colorful) Terms

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

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19.8 Evidence on Acquisitions

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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Evidence on Acquisitions

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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19.9 Divestitures and Restructurings

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 companys stockholders
Split-up company is split into two or more
companies and shares of all companies are distributed
to the original firms shareholders

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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?

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