Mergers

1
Mergers Acquisitions

• FINC 446 Financial Decision Making
• Dr. Olgun Fuat Sahin

2
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

3
Value Related Reasons for MA

• Synergism
• Taxes
• Information Asymmetry
• Agency Costs

4
Synergism

• Synergism Whole is worth more than sum of its
  parts (MA 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

5
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

6
Taxes

• A merger can reduce the tax of a combined firm
  because
  
• The acquirer has large cash flows with limited
  opportunities returning cash to shareholders
  exposes them to taxes
  
• Revaluing assets of the target can create
  depreciation expense for tax purposes
  
• Losses of a target that have been carried forward
  can be used by the combined firm
  
• Alternative Minimum Tax might encourage
  acquisitions by reducing overall tax payment for
  firms if they are combined
  
• Diversification through MA can increase debt
  capacity increasing tax shield

7
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

8
Agency Costs

• MA allows inefficient managers to be replaced
• Activities in the takeover market curb the agency
  cost

9
Management Related Reasons for Mergers

• Reduction of Unsystematic Risk
• Takeover Risk
• Size Preference
• Hubris Hypothesis

10
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

11
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

12
Size Preference

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

13
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

14
MA 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

15
MA 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

16
MA Process (Continued)

• Valuation
• Net Cash Flow
• EBIT x (1 tax rate)
• depreciation and other non-cash expenses
• 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
• acquisition of new assets
• increases ( decreases) in liabilities
• increases ( decreases) in preferred stocks
• Equity residual cash flow

17
MA Process (Continued)

• Valuation
• Should not ignore the value of strategic options
  and payment terms
  
• In general an acquisition creates wealth for the
  acquirer if
  
• Target Alone Synergies Other
• Cash Paid Stock Paid Debt Assumed

What Acquirer Gets
What Acquirer Gives
18
MA 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
  

19
MA 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

20
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
  to receive stock in the acquirer if the bidder
  acquires 100 of the target
  
• Poison pills, flip-in rights allowing holders to
  receive stock in the target
  
• It is effective against raiders who seek to
  acquire controlling interest

21
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

22
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

23
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

24
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
  
• Goodwill will be tested for impairment at least
  annually using a two-step process that begins
  with an estimation of the fair value of a
  reporting unit. The first step is a screen for
  potential impairment, and the second step
  measures the amount of impairment, if any.

25
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
• 151 targets and 126 bidders over 1970-1977

AR is Abnormal Return Actual Expected.
Reported AR is average of firm ARs.
26
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
• 3-day announcement abnormal return for 236
  successful tender offers over 1963-1984

27
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
• 353 targets 241 successful, 112 unsuccessful
• 94 unsuccessful bidders
• 1983-1980

28
Acquirer Performance in the Long-Run

• Long Run Abnormal Return Long-Run Actual Return
  Long-Run Expected Return
  
• Long-Run Event Studies are very sensitive to
  Joint Hypothesis 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

29
Acquirer Performance in the Long-Run (Continued)