Theories of M

1
Theories of MAs
2
Learning Objectives

• At the end of this chapter, you should be able to
  understand
• MAs
• Value increasing
• Value neutral
• Value reducing

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Reasons for Mergers

• Size and returns to scale
• Benefits of size are usual source of synergies
• Economies of scale
• Average costs decline with larger size
• Lower required investment in inventory
• Large firms more able to implement specialization
• Improved capacity utilization
• Economies of scope firm can produce additional
  products due to experience with existing products

4
Reasons for Mergers

• Transaction costs
• Technological factors do not guarantee a merger
  will enhance profit
• Specialization gains suggest reasons mergers
  should not occur
• If supplier can produce input more cheaply, will
  not profit a firm to merge
• Theory of firm
• Firm must decide between internal or external
  production
• Transaction costs within and outside firm
  determine decision on firm size and merger

5
Value Effects of MAs

• Value increasing theories
• Transaction costs reduction firm reacts to
  appropriate balance of internal operations and
  external markets
• Mergers create synergies
• Economies of scale
• More effective management
• Improved production techniques
• Combination of complementary resources
• Takeovers are disciplinary
• Can be used to remove poor managers
• Facilitate competition between different
  management teams

6
Value Effects of MAs

• Value reducing theories
• Agency costs of free cash flow (FCF)
• Free cash flow is a source of value reducing
• Firms with FCF that seek for investment
  opportunities with low NPV
• Managerial entrenchment
• Managers hesitant to distribute cash to
  shareholders
• Investments may be in form of acquisitions where
  managers over pay but reduce likelihood of their
  own replacement

7
Value Effects of MAs

• Value neutral theory hubris
• Merger bids result from managerial hubris
  managers are prone to excessive self confidence
• Winners curse
• Competitive bidding has a distribution of value
  estimates
• Manager with most optimistic forecast wins
  bidding process
• Cursed by fact that bid likely overvalues target
• Mergers can occur even when no value effects
  target sells when bid is higher than target value

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Value Effects of MAs
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Patterns of Gains in MAs
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Examples of the Merger Process

• Reasons given for the merger
• Economies of scale in PC industry
• Projected synergies of 2.5 billion
• Strategic response to conditions in computer and
  information technology sectors
• Market reaction to 9/3/01 announcement
• Hewlett-Packard declined 19
• Compaq fell by 10

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Examples of the Merger Process

• Major events in the merger process
• CEOs initiated discussion in June 2001 firms
  then undertook extensive due diligence
• Consulting firms McKinsey and Accenture were
  involved in the analysis of the merger
• Goldman Sachs (HP) and Salomon Smith Barney
  (Compaq) were engaged in July 2001, to provide
  financial advice
• Members of Hewlett and Packard families
  threatened to vote against the merger
• Shareholders approve in May 2002

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Examples of the Merger Process

• Deal began as a hostile bid by Northrop and
  evolved into merger
• Reasons given for the merger
• Economies of scale in defense industry
• Complementary product mix
• Market reaction to initial announcement (2/22/02)
• TRW increased 26.4 (speculation that there may
  be more potential bidders, or that TRW would get
  a higher price from NG )
• NG dropped by 6.7

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Examples of the Merger Process

• Major events in the merger process
• 2/22/02 Northrop releases letter sent to TRW
  proposing a merger
• 3/3/02 TRW rejected 47 stock offer
• TRW sought other bidders and considered
  implementing a split-up
• Northrop increased offer
• 7/2/02 announced merger agreement for 60 stock

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Example of the Bidding Process Savannah Foods (a
sugar refiner)

• Merger process began in March 1996
• SFs board of directors requested management
  develop a plan to improve shareholder value
• Plan maximize value of core sugar business and
  consider acquisitions in related areas
• Discussions with acquisition candidates and
  merger partners in summer 1996 produced no formal
  actions

15
Example of the Bidding Process Savannah Foods (a
sugar refiner)

• Savannah discussed merger with two possible
  partners in late 1996
• Flo-Sun reached deal to buy SF (7/15/97)
• Shareholders of SF to own 41.5 of new entity
• SF price fell 15.7 to 15.75 at announcement
• Shareholder lawsuits arose over terms
• Imperial Holly, a sugar refining company, made a
  competing bid
• IH contacted investment banking firm, Lehman
  Brothers, to develop acquisition strategies
• IH made competing offer for SF for 18.75 per
  share (70 in cash and 30 in stock)

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Example of the Bidding Process Savannah Foods (a
sugar refiner)

• Flo-Sun upped bid on 9/4/1997
• SF would own 45 of new firm
• Shareholders would also receive 4 in cash
• SF asked both bidders to submit final offers on
  9/8/97
• IH upped bid to 20.25 per share
• Flo-sun stood by most recent offer
• SF executed merger agreement with IH on 9/12/97
• Ended previous agreement with Flo-Sun
• Paid 5 million termination fee to Flo-Sun

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The Merger Process

• Examples demonstrate many complexities in
  negotiating deals
• Bidder considerations
• Pay cash or stock
• Deal with management or shareholders
• May buy initial stake
• Target considerations
• Decision to sell
• Decision to seek competing bids or seek
  termination fee in initial bid

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Models of Takeover Bidding

• The winners curse bidder in takeover risk
  overpaying
• Bidders can shade bids lower but risk losing
  possible deals
• Alternative
• If concerned about value of target, can offer
  stock
• Shares risk of combined firm between bidder and
  target

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Models of Takeover Bidding

• Bidder costs making bid is expensive
• Preemptive bid
• Bidder decides to make bid that precludes other
  bidders from making competing offer
• Target may receive higher price if there is a
  preemptive bidder
• Termination fee bidder making formal offer
  often requires a termination fee in agreement
• Toehold
• Use of toehold helps to recoup bidding costs
• Size of toehold is a function of expected
  synergies from the merger

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Models of Takeover Bidding

• Seller decisions
• Effects of bidder using toehold
• May deter other firms from making competitive
  bids
• But, seller can counteract by designing a
  favorable auction
• Effects of costly bidding
• Selling firm bears most of bidding costs
• Implies that seller may gain by limiting the
  number of bidders

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Example of Takeover Auction Outlet Communications

• Owned and operated television stations
• Board engaged Goldman Sachs to aid in sale via
  auction (auction began 2/95)
• 80 firms contacted GS
• 45 signed confidentiality agreements and received
  non-public information
• By 5/95, 12 firms submitted preliminary bids
  ranging from 32 to 38
• 8 firms invited to perform extensive due
  diligence
• By 6/95, 5 had submitted definitive proposals

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Example of Takeover Auction Outlet Communications

• Highest bid was 42.25 by Renaissance
  Communications OC and RC signed a merger
  agreement
• Before deal completed, NBC offered bid of 47.25
  OC approved competing bid
• Example illustrates
• Complexity of bidding process
• Sequential reduction of number of bidders
• Advantages of encouraging multiple bids