Mergers and Acquisitions

Chapter 21

Definition of Terms:
Merger combination of two or more firms to form a single firm. (Relatively co-equal basis). Parent stock retired and new shares are issued. Acquisition the purchase of one firm by another. Can be a controlling share, majority, or all of the target firms stock. Synergy the whole is greater than the sum of its parts Synergistic Merger Postmerger value > sum of separate companies premerger values. (ExxonMobil)

Reasons for engaging in Mergers:

Synergy
Able to get more value than if the companies operate separately. Increased opportunity of managerial specialization Increased order size

Tax Considerations
Profitable companies take advantage of tax savings from merged companies that incur a loss.

Purchase of Assets below Replacement Cost

If Replacement Cost > Market Value, firm is undervalued

Diversification
Earnings stabilization can increase shareholder value.

Reasons for engaging in Mergers:

Managers Personal Incentives
Controlling Company: bigger company = larger executive pay Acquired Company: incentive is to resist takeovers as they want to retain power. A strategy is to engage in defensive mergers (a merger designed to make the company less vulnerable to a takeover).

Breakup Value
If Breakup Value > Market Value, firm is undervalued.

Vertical Integration
Merger of an upstream and downstream firm, to internalize an externality problem, especially when due to double marginalization.

Economies of Scale and Scope

Reduction of fixed and redundant costs Cost advantages when firms provide a variety of products rather than specializing.

Types of Mergers:
Horizontal Merger
Combination of two firms that produce the same type of good or service (In the same line of business) Examples: Daimler-Benz + Chrysler; Vodafone + Airtouch; Exxon + Mobil

Vertical Merger
Merger between a firm and one of its suppliers or customers. Examples: Time Warner (Cable operation) + Turner Corporation (produces CNN, TBS, etc.); Apple + Intel (processors of Apple)

Types of Mergers:
Congeneric Merger
Merger of firms in the same general industry, and these firms do not have any customer or supplier relationship Examples: Citigroups Acquisition of Travelers Insurance; Prudential Financial (insurance) + Bache & Co. (Stocks)

Conglomerate Merger
Merger of companies in totally different industries. Examples: Walt Disney + ABC; Kelso (Investment Company) + Nortek (home building products/systems)

Merger Waves
Late 1800s = Oil, steel, tobacco, other basic industries 1920s = Stock market boom; utilities, communications, and autos 1960s = Conglomerate mergers 1980s = Junk bonds were used to finance acquisitions. Early 2000s = Strategic alliances to compete better. 2007 to present = Acquisitions done as stock price became undervalued because of the recent economic downturn

Hostile vs Friendly Takeover

Friendly Merger
A merger whose terms are approved by the managements of both companies. Companies cooperate in negotiations Example: BDO + EPCI

Hostile Merger
A merger in which the target firms management resists acquisitions. Takeover target is unwilling to be bought or the targets board has no prior knowledge of the offer. Vodafone Airtouch + Mannesmann AG (exchange of shares between two corporations) Can be done through:
Tender Offer (Buy stock from the stock market, frequently without the knowledge of target companys management). Proxy Fight (Induce Simple Majority of SHs to change management)

Merger Regulation
Williams Act (1968)
Objectives:
Regulate the way acquiring firms structure takeover offers. Force acquiring firms to disclose more information about their offers.

Restrictions on Acquiring Firms:

Current holdings and future intentions must be disclosed within 10 days of amassing at least 5% of company stock. Source of funds must be disclosed. Target firms SHs must have at least 20 days to tender their shares (offer open at least 20 days) If acquirer increases offer price within the 20 day open period, all SHs who tendered before the new offer must receive the higher price.

 To value a firm means to value the equity (buying from owners) rather than the total value (not from creditors). Equity Residual Method Valuation Methods:
Proactive Model: Discounted Cash Flow Approach (needs pro forma CF statements and discount rate) Reactive Models: Market Multiple Method (Multiples or Relative Valuation) Liquidation (Breakup Valuation)

Analysis of Mergers

Classification of Mergers: Financial Merger

Firms involved wont be operated as a single unit (no expected synergies) and from which no operating economies are expected. Expected CFs = Incremental Post-Merger CFs

Operating Merger Operations of the firms involved are integrated in hope of achieving synergistic benefits (there are expected synergies).

Discounted Cash Flow Method - Precise

1. Forecast free cash flows FCFE = Net Income + Non-cash items Changes in NWC Net CAPEX + Net Borrowings

2. Obtain a relevant discount rate Use cost of equity, not WACC; ke = rfr + B (MRP) 3. Discount the forecast cash flows and sum to estimate the value of the target.
CF CFt CF1 CF2 V0 ... (1 k )1 (1 k ) 2 (1 k ) t 1 (1 k )t

V0

CF1 kg

ST-2
Mos Burger, an international burger chain, is considering purchasing a smaller chain, Laya Buns. Mos Burgers analysts project that the merger will result in incremental net cash flows of P1.3 million in Year 1, $2.1 million in Year 2, P3.05 million in Year 3, and P5.4 million in Year 4. In addition, Layas Year 4 cash flows are expected to grow at a constant rate of 6% after Year 4. Assume that all cash flows occur at the end of the year. The acquisition will be made immediately if it is undertaken. Layas post-merger beta is estimated to be 1.45, and its post-merger tax rate would be 40%. The risk-free rate is 5%, and the market risk premium is 4%. What is the value of Laya Buns to Mos Burger?

Market Multiple Analysis - Judgmental

Applies a market-determined multiple to NI, EPS, Sales, Book Value, etc. Steps:
1. Find appropriate comparators 2. Adjust/normalize the data (IS and BS) for differences between target and comparator, eg: a) Accounting Differences; b) Different Capital Structures 3. Calculate a variety of ratios for both the target and the comparator, eg: P/E, Value/EBITDA, P/B, ROE 4. Obtain a range of justifiable values based on the ratios.

Graphical Analysis of Mergers

Change in SH Wealth Acquirer

MV or Current Price of Target

Target Equilibrium

PV of FCF (DCF)

Price paid for Target

Synergy = Bargaining Range

Illustrative Short Problems:

Tinghsin Corporation is interested in acquiring Weichun Corporation. Assume that risk free rate of interest is 5% and market risk premium is 6%.

21-1 Weichun currently expects to pay a year-end dividend of P2 a share. Van Burens dividend is expected to grow at a constant rate of 5% a year, and its beta is 0.9. What is the current price of Weichuns stock? 21-2 Tinghsin estimates that if it acquires Weichun, the year-end dividend will remain at P2 a share, but synergies will enable the dividend to grow at a constant rate of 7 percent a year. Tinghsin also plans to increase the debt ratio of what would be its Weichun subsidiary the effect of this would be to raise Weichuns beta to 1.1. What is the per-share value of Weichun to Tinghsin Corporation? 21-3 On the basis of your answers to Problems 21-1 and 21-2, if Tinghsin were to acquire Weichun, what would be the range of possible prices that it could bid for each share of Weichun common stock?

Seatwork By 2s
Cyclone Software Co. is the target of a takeover bid. Its current capital structure consists of 25% debt and 75% equity. After the merger, the firm is expected to use more debt. The risk free rate is 5% the MRP is 6%, and tax rate is 40%. Currently, Cyclones re = 14%, which is determined on the basis of CAPM. Assuming that year end dividend before and after change of capital structure and merger is expected to be 5, and growth rate before and after change in capital structure and merger is 3% and 7%, respectively:
What would be Cyclones estimated ke if it were to change its capital structure from its present capital structure to 50% debt and 50% equity? What is the current price of the stock? (Immediately before the merger) What is the new price of the stock? (After the merger) What is the synergistic benefit if one can buy the stock using the current price of the stock immediately before the merger?

Issues that need to be resolved in Merger Analysis

Price to be paid for the target firm Employment/Control Situation
Buyout of Private Company Owner/Manager of the acquired company would be interested to keep his high status position. Buyout of Public Company Acquired firms manager will be worried about their postmerger positions
Old management retained = Old Mgt would be willing to recommend its acceptance to the stockholders Old management removed = Old Mgt would probably resist the merger.

Consolidation Merger (Equals) What percentage of the ownership do each merger partners shareholders receive?
* Target may retain its identity (be a subsidiary) or it may be dissolved (one of the firms divisions).

Methods of Acquiring the Target Company

Purchase of Targets Assets
Target firm is usually dissolved and no longer continues to exist as a separate legal entity. Simple acquisition of assets and not saddled with any hidden liabilities Common for small to medium sized firms.

Purchase of Targets Stocks

Direct = Tender Offer (Hostile) Indirect = Through the BODs (Friendly) Acquiring firm is responsible for any legal contingencies against the target even those that have occurred prior to the takeover.

Payment Methods:
Cash
Taxable Event

Stock of Acquiring Firm

Mere Exchange of stocks = Nontaxable Event = Nontaxable Offer Target SHs who receive shares of the acquiring companys stock dont have to pay taxes at the time of the merger. They pay taxes ONLY when they sell the stocks that were given to them in exchange AT A GAIN.

Debt of the Acquiring Firm

Taxable Event

Combination of the Above.

Alternative Ways to Structure Takeover Bids:

Taxes Securities Laws

Illustration:
Book Value of Asset Appraised Value Offer Price 100 150 225

Taxable (Pay through Cash or Debt) Nontaxable (Pay through Stock)

Target Firm pays tax on gain of 125m. Assuming 40% tax rate, Tax is 50m, thus only 75m is to be distributed to the target firm's shareholders.
Tax burden of target SHs would be high because they must still pay for individual taxes on any of their own gains.

Acquiring firm simply adds the 100m book value to its own assets and depreciate using their previous depreciation schedules

Taxable Events vs. Nontaxable Events

Acquirers Viewpoint:
Has 2 advantages when it makes taxable offers
Assets are recorded at appraised values (usually greater) and are depreciated accordingly (more tax savings). Goodwill can be recorded (TAC FV of net assets) which can subsequently be amortized (more tax savings) Not applicable nowadays.

Target Company and Target SHs Viewpoint:

Prefer payment through stock as it is a nontaxable event. For taxable events, taxes are assessed at both the corporate and individual levels

Securities Laws
Hostile Takeovers
Nearly all hostile tender offers are for cash to expedite the process as the target may implement defensive tactics and other firms to make competing offers. 1968 Williams Act

Financial Reporting for Mergers

Pooling of Interest
Shares, not cash, must be exchanged. Merger among equals. Consolidated BS = BS of Company A + BS of Company B.

Purchase Accounting
Cash, debt, or stocks may be used to buy the target. IF TAC = NAV or TA TL, Consolidated BS under Purchase Accounting = Consolidated BS under Pooling of Interest. If TAC > FV of Net Assets, Goodwill is recorded. If TAC < FV, Gain on BPO is recorded. Assets of the acquired company are adjusted to their fair value.

Pooling of Interest
Parent Current Assets Fixed Assets Goodwill Total Assets Debt Common Equity Total Debt and Common Equity 50 50 100 40 60 100 Subsidiary 25 25 50 20 30 50 Consolidated 75 75 150 60 90 150

Purchase Accounting
Parent Current Assets Fixed Assets Goodwill Total Assets Debt Common Equity Total Debt and Common Equity 50 50 100 40 60 100 Subsidiary Book Value 25 25 50 20 30 50 Scenario 1 Sub - Fair Value 25 15 40 20

Parent paid 20 for the Net Assets of the Subsidiary through the issuance of 20 worth of common stock.

Purchase Accounting
Parent Current Assets Fixed Assets Goodwill Total Assets
Debt Common Equity Total Debt and Common Equity

50 50
100 40 60 100

Subsidiary Book Value 25 25

50 20 30 50

Scenario 2 Sub - FV 25 25
50 20

Parent paid 30 for the Net Assets of the Subsidiary through the issuance of 30 worth of common stock.

Purchase Accounting
Current Assets Fixed Assets Goodwill Total Assets

Parent Subsidiary Scenario 3 Book Value Sub - FV 50 25 30 50 25 30

100 50 60

Debt Common Equity Total Debt and Common Equity

40 60 100

20 30 50

20

Parent paid 50 for the Net Assets of the Subsidiary through the issuance of 50 worth of common stock.

Income Statement Effects

Increase in fixed assets = higher depreciation charge, decreases NI Increase in inventories = higher CGS, decreases NI

Analysis for Merger of Equals

Develop consolidated pro forma financial statements Estimate the consolidated companys new ke Decide allocation of consolidated stock between two sets of old shareholders. Fair solution share using premerger proportions, if cannot pinpoint which company gives the synergistic benefit.

 Arrange Mergers

Role of Investment Bankers:

Match acquirers (w/ excess cash) with targets (undervalued firms) Illegal Parking Violation are sometimes committed by investment bankers.

Develop Defensive Tactics

Help target firms to protect themselves against hostile takeovers Methods:
Changing By-Laws Convince Target SHs that offer or bid price is too low. Raising antitrust issues (eg: Monopolies Microsoft and Intuit) Stock repurchase to increase price of stock and discourage takeover. (Risk of greenmail) Getting a White Knight or a White Squire Sandbag Pac-Man People Pill, Poison/Suicide Pills, Macaroni Defense, Golden parachute

Role of Investment Bankers:

Establish Fair Value (Value Target Companies)
Acquiring firm would want to know the lowest price it can buy the targets stock Target firm may seek help in proving that price offered is too low.

Finance Mergers
When there is no excess cash Investment bankers must offer a financing package to clients in order for the M&A to be successful

Invest in stocks of potential merger candidates

Do Arbitrage Operations, specifically Risk Arbitrage.

Is there Value Creation And for Whom?

How research on the effects of mergers on shareholder wealth is done?
Examine both acquiring and target firms stock price responses to mergers and tender offers.

Results of Empirical Studies:

Acquisitions do create value Shareholders of target firms reap virtually all the benefits.
Average increase of target firms (hostile) = 30% Average increase of target firms (friendly) = 20%

Is there Value Creation And for Whom?

Increase in shareholder wealth detrimental to bondholders?
No evidence May generally be true as investors in a company may be more interested to purchase stocks of a company that has synergistic benefit, rather than its bonds.

Are the research results logical?

Target Firms have the bargaining power. Takeovers are a competitive game amongst potential acquirers. Acquirers may be willing to give up all value created by the merger, as the acquiring company may reap the benefits w/o harming the shareholders.

Percentage of M&A Deals Resulting in Failure

Source: Data derived from Mergers: Why Most Big Deals Dont Pay Off, Business Week, October 14, 2002

Challenges of Postmerger Integration:

Overestimating Synergies Customer Loss Employee Attrition Failure of Supplier Consolidation Inability to track key performance indicators, which could help executives identify problems earlier to keep earnings on track Slow and incomplete integration

Microsoft Stock Price

Yahoo Stock Price

Stock Price Effects Immediately after Offer Announcement:

Pulte Stock Price

Merger Announcement

Merger Approved and Took Place

Centex Stock Price

Merger Announcement

0.975 Pulte Stock for every 1 Centex Stock

Merger Approved and Took Place

Other Terms:
Corporate or Strategic Alliances
A cooperative deal that stops short of a merger. Allows firms to create combinations that focus on specific business lines that offer the most potential synergies. Kinds of Strategic Alliances
Joint Ventures- 2 or more independent companies combine their resources to achieve a specific limited objective (eg: Microsoft/Dreamworks) Vertical Alliances- relationships between organizations in different industries (Combine Expertise to finish a project). Horizontal Alliances- firms from the same industry (To achieve scale, adjust for seasonal changes, or handle niche areas of expertise) Includes Joint marketing agreements. Administrative Alliances (To share functions, increase operational efficiency, and reduce costs)

Eg: HA: Soho Soda, Regional Beer Company (excess bottles) and Brewer (distributor) Anheuser-Busch; VA: McDo and Oil Companies

Other Terms:
Leveraged Buyouts
A small group of investors (usually includes the firms managers) borrows heavily (uses debt) to buy all the shares of a company Debt is paid through the sale of some of the firms assets and/or income generated by the company. Entails large amount of risk due to (leverage) debt taken to buy the company even if substantial profit is expected. Detrimental effect to bondholders bond investment becomes less valuable as money generated by company is used to pay off the new debt. Eg: RJR-Nabisco

Other Terms:
Divestitures
Opposite of Invest The sale of some of a companys operating assets. Types of Divestitures:
Sale of an operating unit to another firm. Spin-Off. Setting up the business to be divested as a separate corporation and then spinning it off to the divesting firms shareholders Carve-Out. Similar to spin-off but selling only some shares. Parent retains control of the subsidiary. Outright liquidation of assets. Assets are sold off piecemeal rather than as an operating entity.

Other Terms:
Divestitures
Motivations for Divestitures:
Firms are more comfortable in sticking with their niche. Cash is needed to finance expansion in their primary business lines Cash is needed to reduce a large debt burden. To unload losing assets that would otherwise drag the company down. Some businesses can operate more efficiently alone than together.

Problems in the Textbook:

21-4 Merger Analysis 21-5 Capital Budgeting Analysis