Mergers and Acquisition

RWJ Chp 30
The Basic Forms of Acquisitions
• There are three basic legal procedures
that one firm can use to acquire another
firm:
– Merger
– Acquisition of Shares
– Acquisition of Assets
 Varieties of Takeovers

Merger

Acquisition Acquisition of Shares

Takeovers Proxy Contest Acquisition of Assets

Going Private
(LBO)
 The Tax Forms of Acquisitions
• If it is a taxable acquisition, selling
shareholders need to figure their cost
basis and pay taxes on any capital gains.
• If it is not a taxable event, shareholders
are deemed to have exchanged their old
shares for new ones of equivalent value.
 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 shares in exchange
for at least 90 percent of the outstanding voting
shares of the acquired firm.
• Purchase accounting is generally used under
other financing arrangements.
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.
 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.
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
– Don’t Forget Transactions Costs
A Cost to Shareholders 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 shareholder’s call
option falls.
• How Can Shareholders Reduce their
Losses from the Coinsurance Effect?
– Retire debt pre-merger.
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.
 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 shares.
 The NPV of a Merger: Cash
Synergy – Premium
NPV of merger to acquirer =
Synergy  VAB  (VA  VB )

Premium = Price paid for B - VB

NPV of merger to acquirer = Synergy - Premium

 VAB  (VA  VB )  [Price paid for B  VB ]

 VAB  VA  VB  Price paid for B  VB

 V AB  V A  Price paid for B
The NPV of a Merger: Ordinary Shares

• The analysis gets muddied up because we

need to consider the post-merger value of
those shares we’re giving away.
Target firm payout    New firm value

New shares issued


Old shares  New shares issued
 Cash versus Ordinary Shares
• Overvaluation
– If the target firm shares are too pricey to buy with
cash, then go with shares.
• Taxes
– Cash acquisitions usually trigger taxes.
– shares 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.
 Defensive Tactics
• Target-firm managers frequently resist takeover
attempts.
• It can start with press releases and mailings to
shareholders that present management’s
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.
 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 shares: a class of common shares
whose value is connected to the performance of a
particular segment of the parent company.
 The Corporate Charter
• 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
 Repurchase Standstill Agreements

• In a targeted repurchase the firm buys back its

own shares 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 shares price falls.
 Exclusionary Self-Tenders
• The opposite of a targeted repurchase.
• The target firm makes a tender offer for its
own shares while excluding targeted
shareholders.
 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 pervious managers into owners.
• This reduces the agency costs of equity
 Other Devices and the Jargon of
Corporate Takeovers
• 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.
• Poison pills are measures of true desperation to
make the firm unattractive to bidders. They reduce
shareholder wealth.
– One example of a poison pill is giving the shareholders in
a target firm the right to buy shares in the merged firm at a
bargain price, contingent on another firm acquiring control.
 Example 1
Lam’s share is trading for RM50 a share while Yeoh’s share
goes for RM25 a share. Lam’s EPS is RM1 while Yeoh’s
EPS is RM2.50. Both are 100% equity financed. Both
companies have one million shares of stock outstanding.

a. What is the post-merger EPS, If Lam can acquire Yeoh’s in

an exchange based on market value, what should be the
post‑merger EPS?

b. Suppose Lam pays a premium of 20% in excess of Yeoh's

current market value. How many shares of Lam must be
given to Yeoh’s shareholders for each of their shares?
c. Based on your results in b, what will
Lam’s EPS be after it acquires Yeoh?

d. If Yeoh were to acquire Lam by

offering a 20% premium in excess of
Lam’s current market price, how
many shares of stock would Yeoh
have to offer, and what would be the
effect on Yeoh’s EPS?
 Example 2
Susie's Pizza is analyzing the possible acquisition of Janet's Electric.
The projected cash flows to debt and equity expected from the
merger are as follows:
Year(s) CF
1 RM150,000
2 170,000
3 200,000
4 200,000
5, 6, … 6% growth per year
The current market price of Janet's debt is RM800,000, the risk‑free
rate is 8%, the required return on the market is 12%, and the beta of
the firm being acquired is 1.5.
a. Determine the maximum price (NPV) Susie can afford to pay.
b. If Janet's current equity value is RM1,100,000 and she demands a
30% premium, will the merger take place?