LESSON FOUR

MERGERS AND TAKE- OVERS

INSTRUCTIONS

1. Read Chapter 32 of Pandey I.M. and the Study Text below.

2. Complete answers to reinforcing questions at the end of the lesson.
3. Check model answers given in lesson 9 of the Study Pack.

CONTENTS

4.1 Merger And Acquisition Defined

Types Of Mergers
Reasons For Mergers
The Overall Merger Process
Reasons Behind Failed Mergers
4.6 Due Diligence
4.7 Making Due Diligence Work
4.8 Financial Terms Of Exchange
4.9 Valuing The Target Firm
Cash Flow Statements
Role Of Investment Bankers In Mergers
Anti-Takeover Defenses
Corporate Alliances
Mergers and Takeovers
2

4.1 MERGER AND ACQUISITION DEFINED

When we use the term "merger", we are referring to the joining of two companies where one new
company will continue to exist.
The term "acquisition" refers to the purchase of assets by one company from another company. In
an acquisition, both companies may continue to exist.

However, throughout this topic we will loosely refer to mergers and acquisitions ( M & A ) as a
business transaction where one company acquires another company. The acquiring company (also
referred to as the predator company) will remain in business and the acquired company (which we
will sometimes call the Target Company) will be integrated into the acquiring company and thus, the
acquired company ceases to exist after the merger.

4.2 TYPES OF MERGERS

Mergers can be categorized as follows:

Horizontal: Two firms are merged across similar products or services. Horizontal
mergers are often used as a way for a company to increase its market share by
merging with a competing company. For example, the merger between Total and
ELF will allow both companies a larger share of the oil and gas market.

Vertical: Two firms are merged along the value-chain, such as a manufacturer
merging with a supplier. Vertical mergers are often used as a way to gain a
competitive advantage within the marketplace. For example, a large manufacturer
of pharmaceuticals, may merge with a large distributor of pharmaceuticals, in order
to gain an advantage in distributing its products.

Conglomerate: Two firms in completely different industries merge, such as a gas

pipeline company merging with a high technology company. Conglomerates are
usually used as a way to smooth out wide fluctuations in earnings and provide more
consistency in long-term growth. Typically, companies in mature industries with
poor prospects for growth will seek to diversify their businesses through mergers
and acquisitions.

REASONS FOR MERGERS

a. Synergy

Every merger has its own unique reasons why the combining of two companies is a
good business decision. The underlying principle behind mergers and acquisitions
( M & A ) is simple: 2 + 2 = 5. The value of Company A is Sh. 2 billion and the value
of Company B is Sh. 2 billion, but when we merge the two companies together, we
have a total value of Sh. 5 billion. The joining or merging of the two companies
creates additional value which we call "synergy" value.

Synergy value can take three forms:

1. Revenues: By combining the two companies, we will realize higher revenues

than if the two companies operate separately.
2. Expenses: By combining the two companies, we will realize lower expenses than
if the two companies operate separately.
3. Cost of Capital: By combining the two companies, we will experience a lower
overall cost of capital.
Mergers and Takeovers
3

For the most part, the biggest source of synergy value is lower expenses. Many
mergers are driven by the need to cut costs. Cost savings often come from the
elimination of redundant services, such as Human Resources, Accounting,
Information Technology, etc. However, the best mergers seem to have strategic
reasons for the business combination. These strategic reasons include:

Positioning - Taking advantage of future opportunities that can be exploited

when the two companies are combined. For example, a telecommunications
company might improve its position for the future if it were to own a broad
band service company. Companies need to position themselves to take
advantage of emerging trends in the marketplace.
Gap Filling - One company may have a major weakness (such as poor
distribution) whereas the other company has some significant strength. By
combining the two companies, each company fills-in strategic gaps that are
essential for long-term survival.
Organizational Competencies - Acquiring human resources and
intellectual capital can help improve innovative thinking and development
within the company.
Broader Market Access - Acquiring a foreign company can give a company
quick access to emerging global markets.

b. Bargain Purchase
It may be cheaper to acquire another company than to invest internally. For
example, suppose a company is considering expansion of fabrication facilities.
Another company has very similar facilities that are idle. It may be cheaper to just
acquire the company with the unused facilities than to go out and build new
facilities on your own.
c. Diversification
It may be necessary to smooth-out earnings and achieve more consistent long-
term growth and profitability. This is particularly true for companies in very
mature industries where future growth is unlikely. It should be noted that
traditional financial management does not always support diversification through
mergers and acquisitions. It is widely held that investors are in the best position to
diversify, not the management of companies since managing a steel company is
not the same as running a software company.
d. Short Term Growth
Management may be under pressure to turnaround sluggish growth and
profitability. Consequently, a merger and acquisition is made to boost poor
performance.
e. Undervalued Target
The Target Company may be undervalued and thus, it represents a good
investment. Some mergers are executed for "financial" reasons and not strategic
reasons. A compay may, for example, acquire poor performing companies and
replace the management team in the hope of increasing depressed values.

4.4 THE OVERALL MERGER PROCESS

The Merger & Acquisition Process can be broken down into five phases:

Phase 1 - Pre Acquisition Review:

The first step is to assess your own situation and determine if a merger and
acquisition strategy should be implemented. If a company expects difficulty in the
future when it comes to maintaining core competencies, market share, return on
Mergers and Takeovers
4

capital, or other key performance drivers, then a merger and acquisition (M & A)
program may be necessary.

It is also useful to ascertain if the company is undervalued. If a company fails to

protect its valuation, it may find itself the target of a merger. Therefore, the pre-
acquisition phase will often include a valuation of the company - Are we
undervalued? Would an M & A Program improve our valuations?

The primary focus within the Pre Acquisition Review is to determine if growth
targets (such as 10% market growth over the next 3 years) can be achieved
internally. If not, an M & A Team should be formed to establish a set of criteria
whereby the company can grow through acquisition. A complete rough plan should
be developed on how growth will occur through M & A, including responsibilities
within the company, how information will be gathered, etc.

Phase 2 - Search & Screen Targets:

The second phase within the M & A Process is to search for possible takeover
candidates. Target companies must fulfill a set of criteria so that the Target
Company is a good strategic fit with the acquiring company. For example, the
target's drivers of performance should compliment the acquiring company.
Compatibility and fit should be assessed across a range of criteria - relative size,
type of business, capital structure, organizational strengths, core competencies,
market channels, etc.

It is worth noting that the search and screening process is performed in-house by
the Acquiring Company. Reliance on outside investment firms is kept to a minimum
since the preliminary stages of M & A must be highly guarded and independent.

Phase 3 - Investigate & Value the Target:

The third phase of M & A is to perform a more detail analysis of the target company.
You want to confirm that the Target Company is truly a good fit with the acquiring
company. This will require a more thorough review of operations, strategies,
financials, and other aspects of the Target Company. This detail review is called
"due diligence." Specifically, Phase I Due Diligence is initiated once a target
company has been selected. The main objective is to identify various synergy values
that can be realized through an M & A of the Target Company. Investment Bankers
now enter into the M & A process to assist with this evaluation.

A key part of due diligence is the valuation of the target company. In the
preliminary phases of M & A, we will calculate a total value for the combined
company. We have already calculated a value for our company (acquiring company).
We now want to calculate a value for the target as well as all other costs associated
with the M & A.

Phase 4 - Acquire through Negotiation:

Now that we have selected our target company, it's time to start the process of
negotiating a M & A. We need to develop a negotiation plan based on several key
questions:

- How much resistance will we encounter from the Target Company?

- What are the benefits of the M & A for the Target Company?
- What will be our bidding strategy?
Mergers and Takeovers
5

- How much do we offer in the first round of bidding?

The most common approach to acquiring another company is for both companies to
reach agreement concerning the M & A; i.e. a negotiated merger will take place.
This negotiated arrangement is sometimes called a "bear hug." The negotiated
merger or bear hug is the preferred approach to a M & A since having both sides
agree to the deal will go a long way to making the M & A work. In cases where
resistance is expected from the target, the acquiring firm will acquire a partial
interest in the target; sometimes referred to as a "toehold position." This toehold
position puts pressure on the target to negotiate without sending the target into
panic mode.

In cases where the target is expected to strongly fight a takeover attempt, the
acquiring company will make a tender offer directly to the shareholders of the
target, bypassing the target's management. Tender offers are characterized by the
following:

- The price offered is above the target's prevailing market price.

- The offer applies to a substantial, if not all, outstanding shares of stock.
- The offer is open for a limited period of time.
- The offer is made to the public shareholders of the target.

A few important points worth noting:

- Generally, tender offers are more expensive than negotiated M & A's due to the
resistance of target management and the fact that the target is now "in play" and
may attract other bidders.
- Partial offers as well as toehold positions are not as effective as a 100% acquisition
of "any and all" outstanding shares. When an acquiring firm makes a 100% offer
for the outstanding stock of the target, it is very difficult to turn this type of offer
down.

Another important element when two companies merge is Phase II Due Diligence.
As you may recall, Phase I Due Diligence started when we selected our target
company. Once we start the negotiation process with the target company, a much
more intense level of due diligence (Phase II) will begin. Both companies, assuming
we have a negotiated merger, will launch a very detailed review to determine if the
proposed merger will work. This requires a very detail review of the target company
- financials, operations, corporate culture, strategic issues, etc.

Phase 5 - Post Merger Integration:

If all goes well, the two companies will announce an agreement to merge the two
companies. The deal is finalized in a formal merger and acquisition agreement. This
leads us to the fifth and final phase within the M & A Process, the integration of the
two companies.

Every company is different - differences in culture, differences in information

systems, differences in strategies, etc. As a result, the Post Merger Integration
Phase is the most difficult phase within the M & A Process. Now all of a sudden we
have to bring these two companies together and make the whole thing work. This
requires extensive planning and design throughout the entire organization. The
integration process can take place at three levels:
Mergers and Takeovers
6

Full: All functional areas (operations, marketing, finance, human resources, etc.)
will be merged into one new company. The new company will use the "best
practices" between the two companies.
Moderate: Certain key functions or processes (such as production) will be merged
together. Strategic decisions will be centralized within one company, but day to day
operating decisions will remain autonomous.
Minimal: Only selected personnel will be merged together in order to reduce
redundancies. Both strategic and operating decisions will remain decentralized and
autonomous.
If post merger integration is successful, then we should generate synergy values.
However, before we embark on a formal merger and acquisition program, perhaps
we need to understand the realities of mergers and acquisitions.
4.5 REASONS BEHIND FAILED MERGERS

Mergers and acquisitions are extremely difficult. Expected synergy values may not
be realized and therefore, the merger is considered a failure. Some of the reasons
behind failed mergers are:

Poor strategic fit - The two companies have strategies and objectives that are too
different and they conflict with one another.
Cultural and Social Differences - It has been said that most problems can be
traced to "people problems." If the two companies have wide differences in cultures,
then synergy values can be very elusive.
Incomplete and Inadequate Due Diligence - Due diligence is the "watchdog"
within the M & A Process. If you fail to let the watchdog do his job, you are in for
some serious problems within the M & A Process.
Poorly Managed Integration - The integration of two companies requires a very
high level of quality management. In the words of one CEO, "give me some people
who know the drill." Integration is often poorly managed with little planning and
design. As a result, implementation fails.
Paying too Much - In today's merger frenzy world, it is not unusual for the
acquiring company to pay a premium for the Target Company. Premiums are paid
based on expectations of synergies. However, if synergies are not realized, then the
premium paid to acquire the target is never recouped.
Overly Optimistic - If the acquiring company is too optimistic in its projections
about the Target Company, then bad decisions will be made within the M & A
Process. An overly optimistic forecast or conclusion about a critical issue can lead to
a failed merger.

We should also recognize some cold hard facts about mergers and acquisitions. In
the book The Complete Guide to Mergers and Acquisitions, the authors Timothy J.
Galpin and Mark Herndon point out the following:

- Synergies projected for M & A's are not achieved in 70% of cases.
- Just 23% of all M & A's will earn their cost of capital.
- In the first six months of a merger, productivity may fall by as much as 50%.
- The average financial performance of a newly merged company is graded as C - by
the respective Managers.

In acquired companies, 47% of the executives will leave the first year and 75% will
leave within the first three years of the merger.
Mergers and Takeovers
7

4.6 DUE DILIGENCE

There is a common thread that runs throughout much of the M & A Process. It is
called Due Diligence. Due diligence is a very detailed and extensive evaluation of
the proposed merger. In

An over-riding question is - Will this merger work? In order to answer this question,
we must determine what kind of "fit" exists between the two companies. This
includes: Investment Fit - What financial resources will be required, what level of
risk fits with the new organization, etc.?

Strategic Fit - What management strengths are brought together through this M &
A? Both sides must bring something unique to the table to create synergies.
Marketing Fit - How will products and services compliment one another between
the two companies? How well do various components of marketing fit together -
promotion programs, brand names, distribution channels, customer mix, etc?
Operating Fit - How well do the different business units and production facilities fit
together? How do operating elements fit together - labor force, technologies,
production capacities, etc.?
Management Fit - What expertise and talents do both companies bring to the
merger? How well do these elements fit together - leadership styles, strategic
thinking, ability to change, etc.?
Financial Fit - How well do financial elements fit together - sales, profitability,
return on capital, cash flow, etc.?
Due diligence is also very broad and deep, extending well beyond the functional
areas (finance, production, human resources, etc.). This is extremely important
since due diligence must expose all of the major risk associated with the proposed
merger. Some of the risk areas that need to be investigated are:

- Market - How large is the target's market? Is it growing? What are the major
threats? Can we improve it through a merger?
- Customer - Who are the customers? Does our business compliment the target's
customers? Can we furnish these customers new services or products?
- Competition - Who competes with the target company? What are the barriers to
competition? How will a merger change the competitive environment?
- Legal - What legal issues can we expect due to an M & A? What liabilities, lawsuits,
and other claims are outstanding against the Target Company?

Another reason why due diligence must be broad and deep is because management
is relying on the creation of synergy values. Much of Phase I Due Diligence is
focused on trying to identify and confirm the existence of synergies between the two
companies. Management must know if their expectation over synergies is real or
false and about how much synergy can we expect? The total value assigned to the
synergies gives management some idea of how much of a premium they should pay
above the valuation of the Target Company. In some cases, the merger may be
called off because due diligence has uncovered substantially less synergies then
what management expected.

4.7 MAKING DUE DILIGENCE WORK

Since due diligence is a very difficult undertaking, you will need to enlist your best
people, including outside experts, such as investment bankers, auditors, valuation
specialist, etc. Goals and objectives should be established, making sure everyone
understands what must be done. Everyone should have clearly defined roles since
Mergers and Takeovers
8

there is a tight time frame for completing due diligence. Communication channels
should be updated continuously so that people can update their work as new
information becomes available; i.e. due diligence must be an iterative process.
Throughout due diligence, it will be necessary to provide summary reports to senior
level management.

Due diligence must be aggressive, collecting as much information as possible about

the target company. This may even require some undercover work, such as sending
out people with false identities to confirm critical issues. A lot of information must
be collected in order for due diligence to work. This information includes:

Corporate Records: Articles of incorporation, by laws, minutes of meetings,

shareholder list, etc.
Financial Records: Financial statements for at least the past 5 years, legal council
letters, budgets, asset schedules, etc.
Tax Records: Federal, state, and local tax returns for at least the past 5 years,
working papers, schedules, correspondence, etc.Regulatory Records: Filings with
the NSE, reports filed with various governmental agencies, licenses, permits,
decrees, etc.
Debt Records: Loan agreements, mortgages, lease contracts, etc.
Employment Records: Labor contracts, employee listing with salaries, pension
records, bonus plans, personnel policies, etc.
Property Records: Title insurance policies, legal descriptions, site evaluations,
appraisals, trademarks, etc.
Miscellaneous Agreements: Joint venture agreements, marketing contracts,
purchase contracts, agreements with Directors, agreements with consultants,
contract forms, etc.

Good due diligence is well structured and very pro-active; trying to anticipate how
customers, employees, suppliers, owners, and others will react once the merger is
announced. When one analyst was asked about the three most important things in
due diligence, his response was "detail, detail, and detail." Due diligence must very
in-depth if you expect to uncover the various issues that must be addressed for
making the merger work.

4.8 FINANCIAL TERMS OF EXCHANGE

When two companies are combined, a ratio of exchange occurs, denoting the
relative weighting of the firms. The ratio of exchange can be considered in
respect to earnings, market prices and the book values of the two companies
involved.

a. Earnings
In evaluating possible acquisition, the acquiring firm must at least consider
the effect the merger will have on the earnings per share of the surviving
company. We can discuss this through an illustration:

Illustration (4.1)
Company A is considering the acquisition by shares of Company B. The
following information is also available.

Company A Company B
Present earnings Shs 20,000,000 Shs 5,000,000
Shares 5,000,000 2,000,000
Mergers and Takeovers
9

Earnings per share Shs 4 Shs 2.50

Price/earning ratio 16 12
Price of shares Sh 64 Sh 30

Company B has agreed to an offer of Shs 35 a share to be paid in Company A

shares.

REQUIRED:
Consider the effect of the acquisition to the earnings per share.

SOLUTION
The exchange ratio = 35/64 = 0.546875 shares

of Company A's stock for each share of Company B's stock.

The total number of shares needed to acquire company B's share

= 0.546875 X 2,000,000 = 1,093,750 shares of Company A

The earnings per share therefore can be computed as follow:

EPS combined = Earnings of A + Earnings of B

Companies Total No. of shares

= 20,000,000 + 5,000,000
5,000,000 + 1,093,750

= 25,000,000
6,093,750

= Shs 4.10

Therefore the earnings for share of the combined firm is Shs 4.10.
There is therefore an immediate improvement in earnings per share for
Company A as a result of the merger.

However, Company B's former shareholders experience a reduction in

earnings per share. These EPS will be given by

0.546875 X 4.10 = Shs 2.24 from Shs 2.50

b. Future Earnings
If the decision to acquire another company were based solely on the initial
impact on earnings per share, an initial dilution in earnings per share would
stop any company from merging with another. However, due to synergetic
effects discussed earlier, the merger may result in increased future earnings
and therefore a high EPS in future.

c. Market Value
The major emphasis in the bargaining process is on the ratio of exchange of
market price per share. The market price per share reflects the earnings
potential of the company, dividends, business risk, capital structure, asset
values and other factors that bear upon valuation. The ratio of exchange of
market price is given by the following formula:
Mergers and Takeovers
10

Market price ratio = Market price per share of acquiring company X

No. of shares offered
of exchange Market price per share of the acquired
company

Considering the previous example (example 4.1)

Market price ratio = 64 X 0.546875 = 1.167.

30

Therefore, Company B receive more than its market price per share. It is
common for the company being acquired to receive a little more than the
market price per share. Shareholders of the acquired company would
therefore benefit from the acquisition because their shares were originally
worth Shs 30 but they receive Shs 35.

Illustration (4.2)
The following information relates to Company X and Y.

Company X Company Y
Present earnings Shs 20,000,000 Shs 6,000,000
No. of shares 6,000,000,000 2,000,000
Earnings per share Shs 3.33 Shs 3.00
Market price per share Shs 60.00 Shs 30.00
Price/earning ratio 18 10

Company X offers 0.667 shares for each share of Company Y to acquire the
company.

The market price exchange ratio = 60 X 0.667 = 1.33

3

Shareholders of Y are being offered a share with a market value of Shs 40

for each share they own (i.e. 1.333 X 30). They benefit from acquisition with
respect to market price because their shares were formerly worth Shs 30.
We can consider the combined effect.

Combined Effect
Total earnings Shs 26,000,000
No. of shares 7,333,333
Earnings per share Shs 3.55
Price/earning ratio 18
Market price per share Shs 63.90

Note:
Both companies tend to benefit due to the merger. This can be seen by the
increased market price per share for both company. This is due to the
assumption that the price earnings ratio of the combined company will
remain 18. If this is the case, companies with high price/earning ratios can
be able to acquire companies with lower price/earnings ratio to obtain an
Mergers and Takeovers
11

immediate increase in earnings per share (even if they pay a premium for
the share.)

d. Book value
Book value per share is not a useful basis for valuation in most mergers.
However, it may be important if the purpose of an acquisition is to obtain the
liquidity of another company. The ratio of exchange of book value per share
of the two companies are calculated in the same manner as is the ratio for
market values computed above. The application of this ratio in bargaining
is usually restricted to situations in which a company is acquired for its
liquidity and asset values rather than for its earning power.

4.9 VALUING THE TARGET FIRM

To determine the value of the target firm, two key items are needed:

a. A set of proforma financial statements which develop the incremental

cashflows expected from the merger, and
b. A discount rate or cost of capital, to apply to these projected cashflows.

4.10 CASH FLOW STATEMENTS

In a pure financial merger, the post-merger cash flows are simply the sum of
the expected cashflows of the two firms if they were to continue operating
independently. If the two firm's operations are to be integrated however,
forecasting future cashflows is a more complex task.

The following illustration can be used to determine the value of target

company.

Illustration: (4.3)
XYZ Ltd. is considered acquiring ABC Ltd. The following information relates
to ABC Ltd. for the next five years. The projected financial data are for the
post-merger period. The corporate tax rate is 40% for both companies.

Amounts are in Shs `000'

1994 1995 1996 1997 1998
Net sales 1,050 1,260 1,510 1,740 1,910
Cost of sales 735 882 1,057 1,218 1,337
Selling & admn. expenses 100 120 130 150 160
Interest expenses 40 50 70 90 110

Other information

a. After the fifth year the cashflows available to XYZ from ABC is expected
to grow by 10% per annum in perpetuity.
b. ABC will retain Shs 40,000 for internal expansion every year.
c. The cost of capital can be assumed to be 18%.

REQUIRED:

i. Estimate the annual cash flows.

ii. Determine the maximum amount XYZ would be willing to acquire ABC
at.
Mergers and Takeovers
12

SOLUTION:
XYZ LTD

i. PROJECTED POST-MERGER CASHFLOWS FOR ABC LTD.

Amounts in Shs `000'
1994 1995 1996 1997 1998
Net sales 1,050 1,260 1,510 1,740 1,910
Less cost of sales 735 882 1,057 1,218 1,337
315 378 453 522 573
Less selling and admn. costs 100 120 130 150 160
EBIT 215 258 323 372 413
Less interest 40 50 70 90 110
EBT 175 208 253 282 303
Less tax 40% 70 83.2 101.2 112.8 121.2
Net income 105 124.8 151.8 169.2 181.8
Less Retention by ABC 40 40.0 40.0 40.0 40.0
Cash available to XYZ 65 84.8 91.8 129.2 141.75
Add terminal value . . . 1,949.75
Net cash flows 65 84.8 91.8 129.2 2,091.55

Computation of terminal value

TV = 141.8 (1 + 0.1) = Shs 1,949.75

0.18 - 0.10

ii. Assuming the discount rate of 18%, the maximum price of ABC can be
determined by computing the PV of the projected cashflows.

Year Cashflow PVIF18% PV

1 65 0.847 55.055
2 84.8 0.718 60.886
3 91.8 0.607 55.723
4 129.2 0.516 66.667
5 2,091.55 0.437 914.24
1,152.57

The maximum price will therefore be Shs 1,152,570

Note: Estimating the discount rate will be discussed in Lesson 6.

4.11 THE ROLE OF INVESTMENT BANKERS IN MERGERS

The investment banking community is involved with mergers in a number of

ways:

1. They help arrange mergers

The bankers will identify firms with excess cash that might want to buy
other firms, companies that might be willing to be bought and
companies which might be attractive to others.
Mergers and Takeovers
13

2. They help target companies develop and implement defensive

techniques
Target firms that do not want to be acquired generally enlist the help of
an investment banking firm, along with a law firm that specializes in
helping to block mergers. Defensive techniques include:

(a) Changing the by-laws e.g require special resolution (75%) to

approve mergers.
(b) Trying to convince the target firm's shareholders that the price
being offered is too low.
(c) Raising antitrust issues between shareholders of the two firms.
(d) Repurchasing shares in an open market in an effort to push the
prices above that being offered by the potential acquirer.
(e) Being acquired by a more friendly firm.
(f) Taking a poison pill (commiting economic suicide) e.g. borrowing
on terms that require immediate repayment of all loans if the firm
is acquired, selling off at a bargain the assets that originally made
the firm a desirable target, heavy cash overflows in dividends,
executive benefits etc.
3. Establishing a fair value
Investment bankers are experts that can help the firms determine a fair
ratio of exchange that is beneficial (if possible) to both shareholders.
4. They help finance mergers
If the acquiring company has cashflow problems, then investment
bankers will provide required finance for the merger.
They speculate in the shares of potential merger candidates and
thereby make arbitrage gains.

4.12 ANTI-TAKEOVER DEFENSES

Throughout this entire lesson we have focused our attention on making the merger
and acquisition process work. In this final part, we will do just the opposite; we will
look at ways of discouraging the merger and acquisition process. If a company is
concerned about being acquired by another company, several anti-takeover
defenses can be implemented. As a minimum, most companies concerned about
takeovers will closely monitor the trading of their stock for large volume changes.

a. Poison pill
One of the most popular anti-takeover defenses is the poison pill. Poison pills
represent rights or options issued to shareholders and bondholders. These rights
trade in conjunction with other securities and they usually have an expiration
date. When a merger occurs, the rights are detached from the security and
exercised, giving the holder an opportunity to buy more securities at a deep
discount. For example, stock rights are issued to shareholders, giving them an
opportunity to buy stock in the acquiring company at an extremely low price. The
rights cannot be exercised unless a tender offer of 20% or more is made by
another company. This type of issue is designed to reduce the value of the Target
Company. Flip-over rights provide for purchase of the Acquiring Company while
flip-in rights give the shareholder the right to acquire more stock in the Target
Company. Put options are used with bondholders, allowing them to sell-off bonds
in the event that an unfriendly takeover occurs. By selling off the bonds, large
principal payments come due and this lowers the value of the Target Company.
Mergers and Takeovers
14

b. Golden Parachutes
Another popular anti-takeover defense is the Golden Parachute. Golden
parachutes are large compensation payments to executive management, payable
if they depart unexpectedly. Lump sum payments are made upon termination of
employment. The amount of compensation is usually based on annual
compensation and years of service. Golden parachutes are narrowly applied to
only the most elite executives and thus, they are sometimes viewed negatively by
shareholders and others. In relation to other types of takeover defenses, golden
parachutes are not very effective.

c. Changes to the Corporate Charter

If management can obtain shareholder approval, several changes can be made to
the Corporate Charter for discouraging mergers. These changes include:

Staggered Terms for Board Members: Only a few board members are elected
each year. When an acquiring firm gains control of the Target Company,
important decisions are more difficult since the acquirer lacks full board
membership. A staggered board usually provides that one-third are elected
each year for a 3 year term. Since acquiring firms often gain control directly
from shareholders, staggered boards are not a major anti-takeover defense.

Super-majority Requirement: Typically, simple majorities of shareholders are

required for various actions. However, the corporate charter can be
amended, requiring that a super-majority (such as 80%) is required for
approval of a merger. Usually an "escape clause" is added to the charter, not
requiring a super-majority for mergers that have been approved by the Board
of Directors. In cases where a partial tender offer has been made, the super-
majority requirement can discourage the merger.

Fair Pricing Provision: In the event that a partial tender offer is made, the
charter can require that minority shareholders receive a fair price for their
stock. Since many countries have adopted fair pricing laws, inclusion of a
fair pricing provision in the corporate charter may be a moot point. However,
in the case of a two-tiered offer where there is no fair pricing law, the
acquiring firm will be forced to pay a "blended" price for the stock.

Dual Capitalization: Instead of having one class of equity stock, the company
has a dual equity structure. One class of stock, held by management, will
have much stronger voting rights than the other publicly traded stock. Since
management holds superior voting power, management has increased
control over the company.

d. Re-capitalization
One way for a company to avoid a merger is to make a major change in its
capital structure. For example, the company can issue large volumes of debt and
initiate a self-offer or buy back of its own stock. If the company seeks to buy-
back all of its stock, it can go private through a leveraged buy out (LBO).
However, leveraged re-capitalization require stable earnings and cash flows for
servicing the high debt loads. And the company should not have plans for major
capital investments in the near future. Therefore, leveraged recaps should stand
on their own merits and offer additional values to shareholders. Maintaining
high debt levels can make it more difficult for the acquiring company since a low
debt level allows the acquiring company to borrow easily against the assets of
the Target Company.
Mergers and Takeovers
15

Instead of issuing more debt, the Target Company can issue more stock. In many
cases, the Target Company will have a friendly investor known as a "white
squire" which seeks a quality investment and does not seek control of the Target
Company. Once the additional shares have been issued to the white squire, it
now takes more shares to obtain control over the Target Company.

Finally, the Target Company can do things to boost valuations, such as stock
buy-backs and spinning off parts of the company. In some cases, the target
company may want to consider liquidation, selling-off assets and paying out a
liquidating dividend to shareholders. It is important to emphasize that all
restructuring should be directed at increasing shareholder value and not at
trying to stop a merger.

e. Other Anti Takeover Defenses

Finally, if an unfriendly takeover does occur, the company does have some
defenses to discourage the proposed merger:

1. Stand Still Agreement:

The acquiring company and the target company can reach agreement
whereby the acquiring company ceases to acquire stock in the target for a
specified period of time. This stand still period gives the Target Company
time to explore its options. However, most stand still agreements will require
compensation to the acquiring firm since the acquirer is running the risk of
losing synergy values.
2. Green Mail: If the acquirer is an investor or group of investors, it might be
possible to buy back their stock at a special offering price. The two parties
hold private negotiations and settle for a price. However, this type of
targeted repurchase of stock runs contrary to fair and equal treatment for all
shareholders. Therefore, green mail is not a widely accepted anti-takeover
defense.

3. White Knight: If the target company wants to avoid a hostile merger, one
option is to seek out another company for a more suitable merger. Usually,
the Target Company will enlist the services of an investment banker to locate
a "white knight." The White Knight Company comes in and rescues the
Target Company from the hostile takeover attempt. In order to stop the
hostile merger, the White Knight will pay a price more favorable than the
price offered by the hostile bidder.

4. Litigation: One of the more common approaches to stopping a merger is to

legally challenge the merger. The Target Company will seek an injunction to
stop the takeover from proceeding. This gives the target company time to
mount a defense. For example, the Target Company will routinely challenge
the acquiring company as failing to give proper notice of the merger and
failing to disclose all relevant information to shareholders.

5. Pac Man Defense: As a last resort, the target company can make a tender
offer to acquire the stock of the hostile bidder. This is a very extreme type of
anti-takeover defense and usually signals desperation.
One very important issue about anti-takeover defenses is valuations. Many
anti-takeover defenses (such as poison pills, golden parachutes, etc.) have a
tendency to protect management as opposed to the shareholder.
Consequently, companies with anti-takeover defenses usually have less
upside potential with valuations as opposed to companies that lack anti-
Mergers and Takeovers
16

takeover defenses. Additionally, most studies show that anti-takeover

defenses are not successful in preventing mergers. They simply add to the
premiums that acquiring companies must pay for target companies.

4.13 CORPORATE ALLIANCE

Mergers are one way for two companies to completely join assets and
management but many companies enter into corporate deals which fall short
of merging. Such deals are called corporate alliances and they take many
forms, from straight forward marketing agreements to joint ownership of
world scale operations. Joint venture is one method of corporate alliance. In
a joint venture parts of companies are joined to achieve specific limited
objectives. A joint venture is controlled by management teams consisting of
representation of both the two or more parent companies.
Mergers and Takeovers
17

REINFORCING QUESTIONS

QUESTION ONE
The following data are pertinent for companies A and B.

A B
Present Earnings Shs 20 million Shs 4 million
No of shares 10 million 1 million
Price/earning ratio 18 10

a. If the two companies were to merge and the exchange ratio were one
share of Company A for each share of Company B, what would be the
initial impact on earnings per share of the two companies? what is the
market value exchange ratio? Is the merger likely to take place?
b. If the exchange ratio were two shares of Company A for each share of
Company B what would happen with respect to the above?
c. If the exchange ratio were 1.5 shares of Company A for each share of
Company B, what would happen?
d. What exchange ratio would you recommend?

QUESTION TWO
a. "A well planned merger can result to both companies benefiting". Discuss.
b. "Synergy is the necessary mainspring of a successful merger"

REQUIRED:
i. What is synergy?
ii. Discuss the above statement.

QUESTION THREE
X Ltd intends to take-over Y Ltd by offering two of its share for every five shares
in Y Company Ltd. Relevant financial data is as follows:

X Ltd Y Ltd
EPS Shs 2 Shs 2
Market price per share Shs 100 Shs 40
Price earnings ratio 50 20
No. of shares 100,000 250,000
Total earnings Shs 200,000 Shs 500,000
Total market value Shs 10,000,000 Shs 10,000,000

REQUIRED:

a. Compute the combined EPS & MPS

b. Has wealth been created for shareholders?

CHECK YOUR ANSWERS WITH THOSE GIVEN IN LESSON 9 OF THE

STUDY PACK
Mergers and Takeovers
18

COMPREHENSIVE ASSIGNMENT NO.2

TO BE SUBMITTED AFTER LESSON 4

To be carried out under examination conditions and sent to the Distance Learning
Administrator for marking by the University.

EXAMINATION PAPER. TIME ALLOWED: THREE HOURS. ANSWER ALL

QUESTIONS

QUESTION ONE
a. Explain the key issues to be considered by a Financial Manager in the day to
day operations of an enterprise. (10 marks)
b. Discuss the merit of the notion that the Finance Manager's aim is to
maximise the value of the firm in light of the views expressed under the
agency theory. (10 marks)
(Total 20
marks)
QUESTION TWO
Taabu Ltd has an investment opportunity for which the outlay and cashflows are
uncertain. Analysis produced the subjective probability assessments as follows:

Subjective Probability Estimates

OUTLAY ANNUAL CASHFLOWS

Probability Amount (Shs) Probability Amounts (Shs)

0.4 240,000 0.2 42,000

0.3 300,000 0.5 48,000
0.2 360,000 0.3 54,000
0.1 420,000

The cost of capital is assumed at 12 percent, life expectancy of ten years and
salvage value zero.

REQUIRED:

a. Construct a decision tree for this investment to show probabilities payoffs

and expected Net Preset Value (NPV). (10 marks)
b. Calculate the expected NPV using the expected cashflows and the expected
outlays. (5 marks)
c. What is the probability of, and the NPV of the worst possible outcomes? (3
marks)
d. What is the probability of, and the NPV of the best possible outcomes? (3
marks)
e. Compute the probability that this will be a good investment. (3 marks)
(Total 24 marks)

QUESTION THREE
Mergers and Takeovers
19

a. Outline the major government policies that influence business decisions and
financial management.
(6 marks)
b. Briefly, illustrate how government activities affect companies in achieving
their financial objectives. (Give suitable examples in your country).(6 marks)

QUESTION FOUR
Maxi Ltd. is considering acquiring Mini Ltd. Selected financial data for the two
companies are as follow:

Max Ltd. Mini Ltd.

Annual sales (millions) Shs 750 Shs 90

Net income (millions) Shs 60 Shs 7.50
Ordinary shares outstanding (millions)15 3
Earnings per share (EPS) Shs 4 Shs 2.50
Market price per share Shs 44 Shs 20

Both companies are in the 40% income tax bracket.

REQUIRED:

a. i. Calculate the maximum exchange ratio Max Ltd. should agree to if it

expects no dilution in EPS. (6 marks)
ii. How much premium would the shareholders of Mini Ltd. receive on a
price of Shs 24.20.
(4 marks)
b. Calculate Maxi Ltd's post merger EPS if the two companies settled on a
price of Shs 24.20. (4 marks)
c. Calculate Max Ltd's EPS if Mini Ltd. shareholders accept one Shs 6
convertible preference share (stated value Shs 100) for every 5 ordinary
shares they own. (4 marks)
d. Calculate Maxi Ltd's EPS if every 50 shares of Mini Ltd. are exchanged for
one 8% debenture of par value Shs 1,000. (4 marks)
e. What one fundamental assumption have you made in your calculations in b.,
c. and d. above?
(2
marks)
(Total 24 marks)
QUESTION FIVE
Abba investments wants to invest in securities C and D of firms in two different
industries. The following information relates to the two securities.

C D
Expected return 14% 12%
Mergers and Takeovers
20

Standard deviations 5 3
Beta 1.70 1.20
Amount of money invested Shs 720,000 Shs 480,000

REQUIRED:
a. Calculate the expected portfolio return. (5 marks)
b. Calculate the beta of the portfolio. (5 marks)
c. Explain what happens to the portfolio risk if the returns of the two securities
are:
i. Perfectly positively correlated. (5 marks)
ii. Perfectly negatively correlated. (5 marks)
(Total 20
marks)

END OF COMPREHENSIVE ASSIGNMENT No.2

NOW SEND YOUR ANSWERS TO THE DISTANCE LEARNING CENTRE

FOR MARKING
Mergers and Takeovers
21