Chapter 10- Mergers and Acquisition 1

1. Merger or Consolidation
i. Absorption of one firm by another.
ii. Acquirer acquires all of the assets & liabilities of
the target firm.
iii. After the merger, the target firm ceased to exist.
iv. In consolidation, an entirely new firm is created.
Both the target and acquirer terminate their
previous existence and become part of the new
firm

Chapter 10- Mergers and Acquisition 2

 Advantages Disadvantages
1. Legally 1. Must be approved by a
straightforward vote of the shareholders of
2. Avoid the necessity to each firm (usually votes of
transfer title of each the owners of 2/3 of the
individual asset of the shares)
acquired firm to the 2. Often occur disagreement
acquiring firm. as to the fair value, which
3. Cost less may result in an expensive
legal proceeding.

Chapter 10- Mergers and Acquisition 3

2. Acquisition of Stocks
1. purchase firm’s voting stock in exchange for
cash or shares of stock or other securities
2. start as a private offer from management of one
firm to another.
3. offer is taken directly to the selling firm’s
stockholders through tender offer. Tender offer
is a public offer to buy shares of a target
firm.
4. often unfriendly
5. may have minority shareholders.

Chapter 10- Mergers and Acquisition 4

3. Acquisition of Assets
1. buy all of firm’s assets
2. require a formal vote of the shareholders of
the selling firm.
3. costly.
4. involve transfer of titles to assets.
5. avoid the potential problem of having
minority shareholders .

Chapter 10- Mergers and Acquisition 5

 Public offer to buy shares of a target firm
 Offer made by one firm directly to the shareholders

of another firm
 Communicated to target firm’s shareholders by

public announcement

Chapter 10- Mergers and Acquisition 6

1. No vote is required in acquisition of stock. If the
shareholders of target firm do not like the offer, they are
not required to accept it and will not tender their shares.
2. Bidding firm can deal directly with shareholders’ of
target firm.
3. Often unfriendly. Resistance by target firm’s
management often makes the cost of acquisition more
than the cost of merger.
4. Target firm may not be completely absorbed if minority
shareholders hold out in a tender offer.

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1. Horizontal Acquisition- Involve firm in the same
industry. The firm is competing with each other in
their product market. Eg: Hyundai merging with
Proton
2. Vertical Acquisition – Involve firms at different
steps of the production process. E.g.: MAS taking
over all travel agencies.
3. Conglomerate Acquisition – The acquiring and
the acquired firm are not related to each other. E.g.:
Computer firm acquiring Nagoya Textile.

Chapter 10- Mergers and Acquisition 8

 Merger or Consolidation
Acquisitions Acquisition of stocks

Acquisitions of assets

A group of shareholders attempts

Proxy Contest to gain controlling seats in the
BOD by voting new directors
Takeover
All equity shares of a public firm
Going Private
are purchased by a small group of
investors. The shares of the firm
are delisted from stock exchanges
and no longer be purchased in the
open market

Chapter 10- Mergers and Acquisition 9

 Most acquisitions fail to create value for the acquirer
(bidder).
 Synergy occurs if the value of the combined firm after the
merger is greater than the sum of the value of the acquiring
firm and the value of the target firm as separate entities
 The main reason why they do not create value lies in
failures to integrate two companies after a merger.
1. Intellectual capital often walks out the door when
acquisitions aren't handled carefully.
2. 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.

Chapter 10- Mergers and Acquisition 10

 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
usual discounted cash flow model: Incremental CF from
merger at date t discounted at the risk adjusted discount
rate.


T
CFt
Synergy = (1 + r)t
t=1
where
ΔD CFt = Δ Revt – Δ Costst – ΔTaxest – ΔCapital Requirementst

Chapter 10- Mergers and Acquisition 11

Δ CFt = Δ Revt – ΔCostst – ΔTaxest – ΔCapital Requirementst

1.Revenue Enhancement
2.Costs Reduction
3.Lower Taxes
4.Lower Cost of Capital

Chapter 10- Mergers and Acquisition 12

 Increased revenues may come from:
1. Marketing Gains
Improvements can be made in the following:
 Previously ineffective media programming and
advertising efforts
 A weak existing distribution network
 An unbalanced product mix

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2. Strategic Benefits
 Opportunity to take advantage of the competitive
environment if certain situations materialized. E.g. 1: A
sewing machine company acquiring a computer company
which might produce a computer-driven sewing machine.
E.g. 2: Procter & Gamble acquired Charmin Paper Co. to
develop highly interrelated cluster of paper products such
as disposable diapers, paper towels, bathroom tissues and
feminine hygiene products.
3. Market or Monopoly Power.
Reduce competition as to achieve monopoly profits.
Empirical evidence does not suggest that increased
market power is a reason for mergers.

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 Combined firm may operate more efficiently than 2 separate
firms.
1. Economies of Scale (EOS)
- Spreading overhead – sharing of central facilities such as
corporate head quarters, top management and a large main
frame computer
- average cost drops as levels of production increases.
- Diseconomies of scale occur after it reaches optimal
point.
2. Economies of Vertical Integration
- to make coordination of closely related activities
easier
- E.g. 1: Forest product firms that cut timber also own
sawmills and hauling equipment.

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 - to transfer technology (e.g. automobile company
acquiring aircraft company)
- E.g.: Airline companies – own airplanes, hotels, car rental
companies
3. Complementary Resources
- to make better use of existing resources
- to provide the missing ingredient for success
- E.g.: ski equipment store acquire tennis equipment store
to produce more sales for summer and winter.
4. Elimination of Inefficient Management
- changing technology or market condition that require a
restructuring of the corporation because incumbent
managers do not understand changing condition and have
trouble abandoning strategies and styles that they have
formulated.

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 Possible tax gain that can come from
acquisition:
1. Use of tax losses from net operating losses
2. Use of unused debt capacity
3. Use of surplus funds

Chapter 10- Mergers and Acquisition 17

 If two firms
merge, for
example, firm A Before Merger After Merger
and B, they will A B AB
pay lower taxes State State State State State 1 State 2
than if they 1 2 1 2
remain separate
Taxabl 200 -100 -100 200 100 100
 Example: e
Income
 Without merger, Tax 68 0 0 68 34 34
they can not
take advantage Net 132 -100 -100 132 66 66
income
of potential tax
losses.

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1. When firms merge, diversification will occur. The
cost of financial distress is likely to be less for the
combined firm than is the sum of these present
values of the 2 separate firms.
2. The acquiring firm might be able to increase its
debt-equity ratio after a merger creating additional
tax benefits and additional value.

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1. Refers to cash flows available after payment of all
taxes and after all positive NPV projects have been
provided for.
2. Firm might make acquisition with its excess funds
3. In a merger, no taxes are paid on dividends remitted
from the acquired firm-resulting in tax savings.

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1. COC can be reduced when two firms merge
because the cost of issuing securities are
subjected to EOS.
2. Cost of issuing both debt and equity are
much lower for large issues than for smaller
issues.

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 Avoiding Mistakes
1. Do not Ignore Market Values
 Use market price of comparable opportunities to
estimate present value of benefits.
2. Estimate only Incremental Cash Flows
 Only incremental cash flow from an acquisition add
value to the acquiring firm.
3. Use the Correct Discount Rate
 The discount rate should reflect the risk associated
with the use of funds
4. Consider Transactions Costs such as fees to investment
bankers, legal fees, disclosure requirements.

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 The Base Case
- If two all-equity firms merge, there is no transfer of
synergies to bondholders
- Stockholders of both firms are indifferent to the merger
- One Firm has Debt
- The value of the levered shareholder’s call option falls.
- Bondholders gain the coinsurance effect (mutual
guarantee) and the stockholders lose.
- Bondholders will usually be helped by mergers.
- The less risky the combined firm is, the greater the gains to
the bondholders.
- Stockholders of the acquiring firm will be hurt by the
amount that the bondholders gain
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 2 all equity firms merge.
State 1 State 2 State 3 Market
Value
(RM) (RM) (RM) (RM)
Before Merger:
A 80 50 25 60
B 50 40 15 40
Probability 0.5 0.3 0.2
After Merger:
AB 130 90 40 100

Stockholders of A and B are indifferent to the proposed

merger

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Firm A has debt while Firm B is an all-equity firm
Before Merger
Probability 0.5 0.3 0.2
Firm A RM80 RM50 RM25 RM60
Debt RM40 RM40 RM25 RM37
Equity RM40 RM10 RM0 RM23
Firm B RM50 RM40 RM15 RM40
After Merger
Probability 0.5 0.3 0.2
Firm AB RM130 RM90 RM40 RM100
Debt RM40 RM40 RM40 RM40
Equity RM90 RM50 RM0 RM60

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 From the above table, we can see:
◦ Firm A cannot pay the debt claim in full since the NPV = RM25
whereas the value of the debt = RM40. (Under State 3)
◦ Therefore, Debt = (RM40 x 0.50) + (RM40 x 0.30) + (RM25x 0.2)
= RM37
◦ When A and B are separate, B cannot guarantee A’s debt. But after
merger, the bondholders can draw on the cash flows from Firm AB.
Hence, bondholders gain RM3 (RM40 – RM37) from the merger.
◦ This mutual guarantee is called the “coinsurance effect”.
◦ The existing shareholders of A lose RM3 (RM20 – RM23) from merger.

Equity value of A after merger: Equity value of A before

(RM60 – RM40) merger:
(RM60 – RM37)

Equity value of AB Equity value of B

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1. Retire debt pre-merger and reissue an equal
amount of debt after merger.
 Retire at the low, pre-merger price
2. Issue more debt after merger.
Two effects:
(1) interest deduction from new debt increase
firm’s value
(2) Probability of financial distress increase thus
reduce bondholders’ gain from coinsurance
effect.

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1. Earnings Growth
◦ Acquisition can create the appearance of earnings growth.
Example: Selamat acquires Sentosa . The merger creates no value.
Selamat Sentosa Selamat Bhd after Merger
before before The Market The Market
merger merger is “Smart” is “Fooled”

Earnings per share RM1.00 RM1.00 RM1.43 RM1.43

Price per share RM25 RM10 RM25 RM35.71
Price-earnings 25 10 17.5 25
ratio
Number of shares 100 100 140 140
Total Earnings RM100 RM100 RM200 RM200
Total Value RM2,500 RM1,000 RM3,500 RM5,000

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 If market is smart: Since the stock price of Selamat after
merger = before merger, they recognize that the P/E ratio
must fall (from 25 to 17.5)
 If market is fooled: The acquisition of Sentosa increases
Selamat EPS from RM1 to RM1.43. They might think
that the 43% increase is a true growth in the company.
Suppose the P/E of Selamat remains at 25, therefore, total
value of the combined firm increases to RM5,000 (25 x
200). Stock price per share will increase to RM35.71
(RM5,000 /140). This may work only for a while, but in
the long run, the efficient market will force the value
down.

Chapter 10- Mergers and Acquisition 29

2. 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.
Acquiring firm can gain from diversification in 2
conditions: (1) if diversification decreases the
unsystematic variability at lower cost than
investors.
(2) if diversification reduces risk and increases
debt capacity.

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1. Typically, a firm would use NPV analysis when
making acquisitions.
2. The analysis is straightforward with a cash offer,
but gets complicated when the consideration is
stock.
3. NPV analysis is used to quantify the synergy
necessary to justify mergers.
4. Research has discovered that mergers produce little
or no benefits to the acquiring firm. This may
indicate that the merger takes place for reasons
other than synergy or there could be some
weaknesses in the research methodology used.

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NPV of merger to acquirer = Synergy – Premium

Synergy = VAB – (VA + VB)

Premium = Price paid for B – VB
NPV of merger to acquirer = Synergy – Premium
= [VAB – (VA + VB)] – [Price paid for B – VB]
= VAB – (VA + VB) – Price paid for B + VB

= VAB – VA – Price paid for B

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 NPV of merger to acquirer = VB after merger – Cost paid

 VB after merger = VB before merger + Synergy

Chapter 10- Mergers and Acquisition 33

 The analysis gets muddied up because we need to consider the
post-merger value of those shares we’re giving away.

Target firm payout    N ew firm value

New shares issued

Old shares  New shares issued

α = proportion of the shares in the combined firm that firm

B’s shareholders own.

Chapter 10- Mergers and Acquisition 34

1. Overvaluation
◦ If the target firm shares are too expensive to buy with
cash, then go with stock.
◦ If the shares of the acquirer are overvalued, pay by
shares.
2. Taxes
◦ Cash acquisitions usually trigger taxes.
◦ Stock acquisitions are usually tax-free.
3. Sharing Gains from the Merger
◦ With a cash transaction, the target firm shareholders are
not entitled to any downstream synergies.

Chapter 10- Mergers and Acquisition 35

1. In a friendly merger, both companies’ management are
receptive.
2. In a hostile merger, the acquiring firm attempts to gain
control of the target without their approval. Strategies to
gain control in a hostile merger:
a) Tender offer – an offer made directly to the stockholders to buy
shares at a premium above the current market price.
b) Street Sweep – acquirer may continue to buy more shares in the open
market until control is achieved.
c) Proxy fight – a procedure involving corporate voting as an attempt to
win a majority of seats on the BOD to force merger.

Chapter 10- Mergers and Acquisition 36

1. Target-firm managers frequently resist takeover attempts.
2. It can start with press releases and mailings to shareholders
that present management’s viewpoint and escalate to legal
action.
3. Management resistance may represent the pursuit of self
interest at the expense of shareholders.
4. Resistance may benefit shareholders in the end if it results in
a higher offer premium from the bidding firm or another
bidder.

Chapter 10- Mergers and Acquisition 37

1. The Corporate Charter
i. Refers to articles of incorporation and corporate by laws
to govern the firm.
ii. Amend charter to make takeover more difficult such as
instead of 2/3 approval, management require 80%
approval(super-majority amendment)
iii.Stagger the election of the BOD, which increases
difficulty of electing a new BOD quickly.
The adoption of anti-takeover amendments related to corporate
charter has no adverse effects to stock price.

Chapter 10- Mergers and Acquisition 38

2. Golden Parachutes:
◦ Provide compensation to top level management if
takeover occurs. This will make management become
more interested in stockholders’ welfare. Alternatively,
the payment can be seen as an attempt to enrich
management at the stockholders’ expense.
3. Poison Pill:
◦ A right granted to target firm’s stockholders to buy
shares in the merged firm at a bargain price. The right
dilutes the stock that the bidding firm loses money on its
shares. Thus the wealth is transferred from the bidder to
the target.

Chapter 10- Mergers and Acquisition 39

1. Greenmail and Standstill Agreements
◦ In a targeted repurchase the firm buys back its own
stock from a potential acquirer, often at a premium, with
the provision that the seller promises not to acquire the
company for a specified period. This is known as
greenmail
2. Standstill agreements are contracts where acquirer, for a
fee, agrees to limit its holdings in the target. These usually
leads to cessation of takeover attempts. Announcements to
such agreements had a negative effect on stock price.

Chapter 10- Mergers and Acquisition 40

3. White Knight and White Squire:
a) White Knight : A friendly suitor who are arranged to
acquire the target firm in a hostile acquisition. The
white knight is willing to pay a higher purchase price or
it might promise not to lay off employees, fire managers
or sell off divisions.
b) White Squire: If management wishes to avoid any
acquisition, a third party might be invited to make a
significant investment in the firm, under the condition
that it votes with management. The squire is generally
offered shares at a favorable price.

Chapter 10- Mergers and Acquisition 41

4. Recapitalization and Repurchases:
Target management will often issue debt to pay out
a dividend (leveraged recapitalization) This will
fend off takeover in 2 ways:
◦ The stock price will rise which makes acquisition
less attractive to bidder
◦ As part of recapitalization, management may
issue new shares that give management greater
voting control.

Chapter 10- Mergers and Acquisition 42

5. Exclusionary Self-Tenders: a firm makes a tender offers
for a given amount of its stocks while excluding targeted
stockholders
6. Assets Restructurings: Firms may sell off existing assets
(crown jewels) or buy new ones to avoid takeover
7. Going private and leveraged buyouts(LBO): When
publicly owned stock in a firm is purchased by a private
group, (existing management), the stock is taken off the
market (delisted) If the purchase is financed by debt, the
transaction is called leveraged buy-out.

Chapter 10- Mergers and Acquisition 43

1. Shark repellent
Any corporate activity that is undertaken to discourage a
hostile takeover, such as a golden parachute, scorched
earth policy or poison pill.
2. Bear hug
A hostile takeover attempt predicated on making an offer at
a premium large enough to ensure shareholder support
even in the face of resistance from the target's board of
directors. The directors are bound by an obligation to the
shareholders.

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1. In the long run, the shareholders of acquiring firms
experience below average returns.
2. Cash-financed mergers are different than stock-financed
mergers.
3. Acquirers can be friendly or hostile. The shares of hostile
cash acquirers outperformed those of friendly cash
acquirers. One explanation is that unfriendly cash bidders
are more likely to replace poor management.

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