Mergers & Acquisitions

FINC 446 Financial Decision Making Dr. Olgun Fuat Sahin

Mergers and Acquisitions

Vertical merger: forward or backward
integration Horizontal merger: expansion in a particular business line Conglomerate merger: combination of companies from unrelated business lines

Value Related Reasons for M&A

Synergism Taxes Information Asymmetry Agency Costs

Synergism
Synergism: Whole is worth more than sum of its parts
(M&A math is 2 + 2 = 5)
Economies of scale lower costs by combining operations Using excess capacity Spreading fixed costs over larger volume Economies of scope can carry out more activities profitably Producing similar products Backward integration buying a supplier to reduce costs Forward integration moving control one step closer to customers
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Synergism (Continued)
Economies of financing larger companies can raise money more economically The more money raised, the lower the issuance costs on
a per dollar raised Higher liquidity for the securities reducing cost of issuance to the firm

Risk reduction lower unsystematic risk will reduce expected bankruptcy costs Market power larger market share allows control over price
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Taxes

A merger can reduce the tax of a combined firm because:

1. The acquirer has large cash flows with limited opportunities returning cash to shareholders exposes them to taxes 2. Revaluing assets of the target can create depreciation expense for tax purposes 3. Losses of a target that have been carried forward can be used by the combined firm 4. Alternative Minimum Tax might encourage acquisitions by reducing overall tax payment for firms if they are combined 5. Diversification through M&A can increase debt capacity increasing tax shield
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Information Asymmetry
Acquiring company posses information that is
not available to the investors Buying another company implies that the acquiring firm managers have found a bargain

Agency Costs
M&A allows inefficient managers to be
replaced Activities in the takeover market curb the agency cost

Management Related Reasons for Mergers

Reduction of Unsystematic Risk Takeover Risk Size Preference Hubris Hypothesis

Reduction of Unsystematic Risk

Diversification at the firm level will reduce the
unsystematic risk
Previously this was good because lower unsystematic risk reduces expected bankruptcy costs Managers also benefit form lower unsystematic risk because lower variability in earnings increases job security and stabilizes compensation
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Takeover Risk
If a company is target for a proposed
acquisition then the target can make it difficult by acquiring another hard to swallow A defensive acquisition can create a regulatory hurdle for the original suitor as well

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Size Preference
Managers self fulfilling prophecies bigger is
better not necessarily profitable Larger firm can provide more compensation for managers

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Hubris Hypothesis
Hubris hypothesis suggest that acquiring firm
managers rely too much on their abilities to identify, undertake, and manage potential targets Usual outcome of such acquisitions is a disaster admitted by divestitures

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M&A Process

Identify a Target Valuation Mode of Acquisition Mode of Payment Accounting of Acquisition
Note: Regulators (Federal Trade Commission FTC) can block a deal or require substantial asset sell off
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M&A Process (Continued)

Identify a Target:
Based on a sound strategy that can increase shareholders wealth Focus on Value Related Reasons Acquisitions are usually initiated by the acquiring firm Sometimes a target can announce that it is for sale

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M&A Process (Continued)

Valuation: Net Cash Flow:
EBIT x (1 tax rate) + depreciation and other non-cash expenses non acquisition of new assets + increases in liabilities other than LTD = Net cash flow Equity Residual Cash Flow: Net Income preferred dividends + depreciation and other non-cash expenses non acquisition of new assets + increases ( decreases) in liabilities ( + increases ( decreases) in preferred stocks ( = Equity residual cash flow

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M&A Process (Continued)

Valuation:
Should not ignore the value of strategic options and payment terms In general an acquisition creates wealth for the acquirer if: What Acquirer Gets [Target Alone + Synergies + Other] >= [Cash Paid + Stock Paid + Debt Assumed]
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What Acquirer Gives

M&A Process (Continued)

Mode of Acquisition:
Refers to whether a proposed acquisition is friendly or hostile to target managers

Friendly acquisitions are approved by board of directors

of each firm Then shareholders vote on the proposal If no negotiation possibility exists then an acquirer can proceed with a tender offer to target shareholders making it hostile Hostile takeover can be quite time consuming especially when target managers fight against the tender offer
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M&A Process (Continued)

Mode of Payment:
How an acquisition is paid for: cash, stock or mixed

If the stock is believed to be undervalued, then

stock should not be used for payment If the stock is overvalued then the stock payment should/can be used
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Takeover Defense
Golden parachute
A contract designed to give executives substantial compensation if they are dismissed following a takeover

Poison pills, flip-over rights allowing holders flipto receive stock in the acquirer if the bidder acquires 100% of the target Poison pills, flip-in rights allowing holders to flipreceive stock in the target
It is effective against raiders who seek to acquire controlling interest
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Takeover Defense (Continued)

Poison puts
Bond issues that become due if unfriendly takeover occurs

Greenmail
Managers of target buys shares purchased by acquirer at a substantial premium

White knight
A third company acquiring the target with friendly terms
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Accounting Method
There used to be two methods: Pooling of
Interest and Purchase method for acquisitions Pooling of Interest:
It can be used if payment is made in the form of acquirers stock Balance sheet and income statement of the combined company are generated by adding up items
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Accounting Method (Continued)

Purchase method:
Balance sheet of the combined entity is constructed as follows: If the price paid is same as the net asset value (book value total liabilities), balance sheet of the combined company is generated by adding up items If the price paid is less than the net asset value, the assets are written down If the price paid is more than the net asset value, the assets are appraised. If the price is still more than appraised value of net assets, the difference is an asset called goodwill The income statement reflect the depreciation expenses adjusted for the revaluation
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Accounting for Goodwill

The Financial Accounting Standards Board (FASB)
issued two statements changing all that: FASB Statement No. 141 Business Combinations
Requires the purchase method of accounting be used for all business combinations initiated after June 30, 2001

FASB Statement No. 142 Goodwill and Other Intangible

Assets
Changes the accounting for goodwill from an amortization method to an impairment-only approach impairmentGoodwill will be tested for impairment at least annually using a two-step process that begins with an estimation of the fair twovalue of a reporting unit. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any.
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Target and Acquirer Performance around Announcement

Dodd (1980), Merger proposals, management discretion
and stockholder wealth, Journal of Financial Economics, Volume 8, Issue 2, June 1980, Pages 105-137 105151 targets and 126 bidders over 1970-1977 1970Bidders 2-day AR * Successful Sample Size T-statistics 2-day AR Unsuccessful Sample Size T-statistics -1.09% 60 -3.0 -1.24% 66 -2.6 Targets 13.41% 71 23.8 12.73 80 19.1
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* AR is Abnormal Return = Actual Expected. Reported AR is average of firm ARs.

Target and Acquirer Performance around Announcement (Continued)

Bradley, Desai & Kim (1988), Synergistic gains from
corporate acquisitions and their division between the stockholders of target and acquiring firms, Journal of Financial Economics, Volume 21, Issue 1, May 1988, Pages 3-40 33-day announcement abnormal return for 236 successful tender offers over 1963-1984 1963Sample Size Total Sample Single Bidders Multiple Bidders 236 163 73 Bidders 0.00% 0.65% -1.45% Targets 21.6% 22.0% 20.8%
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Target and Acquirer Performance around Announcement (Continued)

Bradley, Desai & Kim (1983), The gains to bidding
firms from merger, Journal of Financial Economics, Volume 11, Issues 1-4, April 1983, Pages 121-139 1121353 targets: 241 successful, 112 unsuccessful 94 unsuccessful bidders 19831983-1980
Sample Size Unsuccessful Targets Subsequently Taken Over Not Subsequently Taken Over 112 86 26 Targets 35.6% 39.1% 23.9%
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Acquirer Performance in the Long-Run Long Long Run Abnormal Return = Long-Run Actual LongReturn Long-Run Expected Return Long Long-Run Event Studies are very sensitive to Joint LongHypothesis Problem
They test two hypotheses There is no abnormal performance after acquisitions Null The method of risk adjustment (estimation of expected return) is
accurate. This is very important since we do not have an asset pricing model that can explain security returns well

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Acquirer Performance in the Long-Run Long(Continued)

Study Franks, Harris and Titman (1991) Sample 399 acquisitions, January 1975December 1984 Expected Returns (1) CRSP equal-weighted market index (2) CRSP value-weighted market index (3) Ten-factor model (4) Eight portfolio benchmark (1) Beta and size (2) Returns Across Time and Securities (RATS) with size adjustment Similar to RATS AR Calculation Jensens in eventtime and calendar-time portfolios Major Results Jensens : Average Abnormal Returns are (1) -0.2, (2) 0.29, (3) -0.11, and (4) -0.11 per month over 36 months. (1) and (2) are significant. Calendar-time portfolios: (2) 0.37 per month and significant (4) does not detect any abnormal performance with sub-samples as well CAAR for (1) is -10.26 for (+1, +60) and significant. CAAR for model (2) is similar. No abnormal performance during Franks, Harris and Titman (1991) study period Abnormal Returns are negative and significant over 3 years after acquisitions but insignificant over 5 years BHAR over five years is -6.5 and insignificant. Cash BHAR is 18.5 and insignificant and Equity BHAR is -25 and significant CAARs for mergers and tender offers are -4.04 and 8.85, respectively. Both figures are statistically significant BHAR is zero for all acquisitions after adjusting for cross-sectional dependence, CTAR is negative and significant for equity financed acquisitions.

Agrawal Jaffe, and Mandelker (1992) Loderer and Martin (1992) Loughran and Vijh (1997)

1,164 acquisitions, January 1955December 1987 1,298 acquisitions, 1955-1986 947 acquisitions, 1970-1989

CAAR, starting with AD

CAAR, starting with effective date (ED) Buy-and-Hold Abnormal Return (BHAR) starting with ED CAAR, starting with CD BHAR and CalendarTime Abnormal Return (CTAR)

Matching firm based on size and book-to-market

Rau and Vermaelen (1998) Mitchell and Stafford (2000)

3,517 acquisitions, January 1980December 1991 2,193 acquisitions, 1958-1993

Size and book-to-market matching portfolios Size and book-to-market matching portfolios

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