Corporate Finance Ross Westerfield Jaffe

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Chapter Thirty
30
Mergers and Acquisitions
Corporate Finance Ross ? Westerfield ? Jaffe
Sixth Edition
Prepared by Gady Jacoby University of
Manitoba and Sebouh Aintablian American
University of Beirut
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Chapter Outline

• 30.1 The Basic Forms of Acquisitions
• 30.2 The Tax Forms of Acquisitions
• 30.3 Accounting for Acquisitions
• 30.4 Determining the Synergy from an Acquisition
• 30.5 Source of Synergy from Acquisitions
• 30.6 Calculating the Value of the Firm after an
  Acquisition
• 30.7 A Cost to Stockholders from Reduction in
  Risk
• 30.8 Two "Bad" Reasons for Mergers
• 30.9 The NPV of a Merger
• 30.10 Defensive Tactics
• 30.11 Some Evidence on Acquisitions
• 30.12 Summary and Conclusions

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30.1 The Basic Forms of Acquisitions

• There are three basic legal procedures that one
  firm can use to acquire another firm
• Merger
• Acquisition of Stock
• Acquisition of Assets
• Although these forms are different from a legal
  standpoint, the financial press frequently does
  not distinguish among them.
• In our discussions, we use the term merger
  regardless of the actual form of the acquisition.

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Merger or Consolidation

• A merger refers to the absorption of one firm by
  another. The acquiring firm retains its name and
  identity, and acquires all the assets and
  liabilities of the acquired firm. After the
  merger, the acquired firm ceases to exist as a
  separate entity.
• A consolidation is the same as a merger except
  that an entirely new firm is created. In a
  consolidation, both the acquiring firm and the
  acquired firm terminate their previous legal
  existence.
• An advantage of using a merger to acquire a firm
  is that it is legally straightforward and does
  not cost as much as other forms of acquisition.
• A disadvantage is that a merger must be approved
  by a vote of the shareholders of each firm.

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Acquisition of Stock

• A firm can acquire another firm by purchasing
  target firms voting stock in exchange for cash,
  shares of stock, or other securities.
• A tender offer is a public offer to buy shares
  made by one firm directly to the shareholders of
  another firm.
• If the shareholders choose to accept the offer,
  they tender their shares by exchanging them for
  cash or securities.
• A tender offer is frequently contingent on the
  bidders obtaining some percentage of the total
  voting shares.
• If not enough shares are tendered, then the offer
  might be withdrawn or reformulated.

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Acquisition of Assets

• One firm can acquire another by buying all of its
  assets.
• A formal vote of the shareholders of the selling
  firm is required.
• Advantage of this approach it avoids the
  potential problem of having minority shareholders
  that may occur in an acquisition of stock.
• Disadvantage of this approach it involves a
  costly legal process of transferring title.

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A Classification Scheme

• Financial analysts typically classify
  acquisitions into three types
• Horizontal acquisition when the acquirer and the
  target are in the same industry.
• Vertical acquisition when the acquirer and the
  target are at different stages of the production
  process example an airline company acquiring a
  travel agency.
• Conglomerate acquisition the acquirer and the
  target are not related to each other.

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A Note on Takeovers

• Takeover is a general and imprecise term
  referring to the transfer of control of a firm
  from one group of shareholders to another.
• Takeover can occur by acquisition, proxy
  contests, and going-private transactions.
• In a proxy contest, a group of shareholders
  attempts to gain controlling seats on the board
  of directors by voting in new directors.
• A proxy authorizes the proxy holder to vote on
  all matters in a shareholders meeting.

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Varieties of Takeovers
Takeovers
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30.2 The Tax Forms of Acquisitions

• In a taxable acquisition, the shareholders of the
  target firm are considered to have sold their
  shares, and they will have capital gain/losses
  that will be taxed.
• In a tax-free acquisition, since the acquisition
  is considered an exchange instead of a sale, no
  capital gain or loss occurs.

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30.3 Accounting for Acquisitions

• The Purchase Method
• The source of much goodwill
• Pooling of Interests
• 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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30.4 Determining the Synergy from an 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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30.5 Source of Synergy from Acquisitions

• Revenue Enhancement
• Cost Reduction
• Including replacing ineffective managers.
• Tax Gains
• Net Operating Losses
• Unused Debt Capacity
• The Cost of Capital
• Economies of Scale in Underwriting.

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30.6 Calculating the Value of the Firm after an
Acquisition

• 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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30.7 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
• One Firm has Debt
• The value of the levered shareholders call
  option falls.
• How Can Shareholders Reduce their Losses from the
  Coinsurance Effect?
• Retire debt pre-merger.

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30.8 Two "Bad" Reasons for Mergers

• Earnings Growth
• Only 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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30.9 The NPV of a Merger

• 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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The NPV of a Merger Cash

• NPV of merger to acquirer

Synergy Premium
Premium Price paid for B - VB
NPV of merger to acquirer Synergy - Premium
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The NPV of a Merger Common Stock

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

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Cash versus Common Stock

• Overvaluation
• If the target firm shares are too pricey to buy
  with cash, then go with stock.
• Taxes
• Cash acquisitions usually trigger taxes.
• Stock acquisitions are usually tax-free.
• Sharing Gains from the Merger
• With a cash transaction, the target firm
  shareholders are not entitled to any downstream
  synergies.

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30.10 Defensive Tactics

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

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Divestitures

• The basic idea is to reduce the potential
  diversification discount associated with
  commingled operations and to increase corporate
  focus.
• Divestiture can take three forms
• Sale of assets usually for cash
• Spinoff parent company distributes shares of a
  subsidiary to shareholders. Shareholders wind up
  owning shares in two firms. Sometimes this is
  done with a public IPO.
• Issuance if tracking stock a class of common
  stock whose value is connected to the performance
  of a particular segment of the parent company.

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The Control Block and The Corporate Charter

• If one individual or group owns 51-percent of a
  companys stock, this control block makes a
  hostile takeover virtually impossible.
• Control blocks are typical in Canada, although
  they are the exception in the United States.
• The corporate charter establishes the conditions
  that allow a takeover.
• Target firms frequently amend corporate charters
  to make acquisitions more difficult.
• Examples
• Staggering the terms of the board of directors.
• Requiring a supermajority shareholder approval of
  an acquisition

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Repurchase Standstill Agreements

• In a targeted repurchase the firm buys back its
  own stock from a potential acquirer, often at a
  premium.
• Critics of such payments label them greenmail.
• Standstill agreements are contracts where the
  bidding firm agrees to limit its holdings of
  another firm.
• These usually leads to cessation of takeover
  attempts.
• When the market decides that the target is out of
  play, the stock price falls.

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Exclusionary Offers and Nonvoting Stock

• The opposite of a targeted repurchase.
• The target firm makes a tender offer for its own
  stock while excluding targeted shareholders.
• An example
• In 1986, the Canadian Tire Dealers Association
  offered to buy 49 of the companys voting shares
  from the founding Billes family.
• The offer was voided by the OSC, since it was
  viewed as an illegal form of discrimination
  against one group of shareholders.

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Going Private and LBOs

• If 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
  previous managers into owners.
• This reduces the agency costs of equity

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Other Defensive Devices

• Golden parachutes are compensation to outgoing
  target firm management.
• Crown jewels are the major assets of the target.
  If the target firm management is desperate
  enough, they will sell off the crown jewels.
• White Knight is a friendly bidder who promises to
  maintain the jobs of existing management.
• Poison pills are measures of true desperation to
  make the firm unattractive to bidders. They
  reduce shareholder wealth.

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30.11 Some Evidence on Acquisitions Stock Price
Changes in Successful U.S. Corporate Takeovers

• Takeover Successful
• Technique Targets Bidder

Tender offer 30 4
Merger 20 0 Proxy
contest 8 NA
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Abnormal Returns in Successful Canadian Mergers

• Target Bidder
• Mergers 1964--83 9 3
• Going private
• Transactions 1977--89 25 NA
• - Minority buyouts 27 NA
• - Non-controlling bidder 24 NA

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Comparison of U.S. vs. Canadian Mergers

• The evidence both in U.S. and Canada strongly
  suggests that shareholders of successful target
  firms achieve substantial gains from takeovers.
• Shareholders of bidding firms earn significantly
  less from takeovers. The balance is more even for
  Canadian mergers than for U.S. ones.
• The reasons may be
• There is less competition among bidders in
  Canada.
• The Canadian capital market is smaller.
• There are federal government agencies to review
  foreign investments.

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30.12 Summary and Conclusions

• The three legal forms of acquisition are
• Merger and consolidation
• Acquisition of stock
• Acquisition of assets
• MA requires an understanding of complicated tax
  and accounting rules.
• The synergy from a merger is the value of the
  combined firm less the value of the two firms as
  separate entities.

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30.12 Summary and Conclusions

• The possible synergies of an acquisition come
  from the following
• Revenue enhancement
• Cost reduction
• Lower taxes
• Lower cost of capital
• The reduction in risk may actually help existing
  bondholders at the expense of shareholders.