Financial Management 2

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Mergers and Acquisitions; Divestitures

Mergers and Acquisitions; Divestitures

The lessons covered by this module include the following: Nature and kinds
of mergers and acquisitions, reasons for business combinations, valuing a
merger, meaning and types of divestitures
At the end of the module, the students should be able to
1. Understand the nature and kinds of mergers and acquisitions.
2. Know the reasons why business combinations occur.
3. Understand merger valuation
4. Understand and explain the different modes of payment in mergers and
acquisitions.
5. Understand the meaning of tender offer and how to resist it.
6. Know the meaning and types of divestitures.

Introduction
Issues on mergers, acquisitions, and divestitures have been part of the
business news nowadays. These events or ways of restructuring companies,
in terms of their assets or even financial, are part of their attempts, so with
the industry where they belong, to be more competitive not only in the
domestic market but also globally.

Mergers and Acquisitions

Nature and Definition of Mergers and Acquisitions
Mergers and acquisitions (M&A) is an area of corporate finance and strategy
that deals with the purchase or consolidation with other business entities. It
involves different transactions like mergers, acquisitions, consolidations,
tender offers, purchasing of assets, and management acquisitions.
A merger is a transaction involving the combination of two companies to
form one firm. The acquired company’s existence ends and becomes a part of
the acquiring firm.
(Company A + Company B) Company A
An acquisition, on the other hand, involves a firm buying another firm and
no new company was formed.
(Company X + Company Y) Company X
A consolidation is a type of merger in which an entirely new firm was
created.

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(Company R + Company S) Company T

Mergers and acquisitions, despite their different definitions, are often
interchanged.
Parties involved in acquisition:
1. The target company – one that is being acquired.
2. The acquirer company – the firm that is purchasing the target company.
Kinds of Mergers
1. Horizontal merger – Combining two companies in the same industry.
They are usually competitors. The main objectives of horizontal mergers
are to benefit from economies of scale, reduce competition, achieve
monopoly status and control the market.
Examples: Facebook and Instagram; Disney and Pixar Studios
2. Vertical merger - Also called vertical integration, two companies are in
the same line of production but the production stage is different. It is
merger between a manufacturer and a supplier. Reasons for vertical
mergers:
a. To reduce fixed costs
b. To eliminate other costs such as searching for prices, contracting cost,
collections of receivables, advertisement
c. To plan inventory better.
Example of vertical merger is Microsoft buying Nokia for is software
support and provides necessary hardware for its smartphone.
Other examples are a tire manufacturer acquires a rubber manufacturer,
a car manufacturer acquires a steel company, a textile company acquires
a cotton yarn manufacturer etc.
3. Conglomerate merger – combining two companies who are in different
line of businesses. This merger occurs to expand and stretch the risks in
instances where the current business ceases producing enough income. It
is said that the main objective of a conglomerate merger is to create one
big company.
Examples are: San Miguel Corporation buying Philippine Air Lines and Air
Philippines; Walt Disney Company and the American Broadcasting
Company.

There are two types of conglomerate mergers:

a) Pure conglomerate mergers – are mergers that involve companies
with nothing in common.
b) Mixed conglomerate mergers – consist of firms that are eyeing for
product extensions or market extensions. The main purpose is to gain
access to a wider market or expanding the range of products or
services that they are providing.

There are also some subdivisions of conglomerate mergers such as

financial conglomerates, concentric companies, and management
conglomerates.
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Motives for Mergers and Acquisitions

Below are some of the reasons why mergers and acquisitions take place:
1. Synergy
Strategically, synergy is the main motive behind mergers and acquisitions.
That is improving the firm’s performance for its stakeholders, particularly
the shareholders, through the concept that the value and performance of two
firms when combined will be much greater than the sum of the separate
individual companies. If the whole is greater than the sum of its parts, then,
there is synergy. This may result to the elimination of overlapping or
redundant functions in production and marketing.

2. Growth

Mergers or acquisitions bring about more resources at the disposal of a

company, thus, the most likely increase in its growth. The combination of
expertise, assets, and market shares of two companies can lead to more
optimistic opportunities in the market. Increased market share will most
likely create more openings for revenues and profitability.

3. Acquiring distinctive capabilities

For some firms, mergers and acquisitions will help them acquire unique
competencies or resources that will help the company to perform much better or
effect a change in its concept or standard. The acquiring company may gain
access to the target firm’s patents and licenses or other technology which can
significantly increase revenues and net income. Combination of resources and
experiences can also lead to innovation and efficiency to the company.

4. Cost Reduction

Low cost of production due to the elimination or reduction of overlapping

or unnecessary resources is one of the effects of merger. This will result
to economies of scale or the lowering of the average cost of producing
goods or services as the company expands. Merger will also result to the
generation of savings because of the intermixed of inputs in producing
numerous products. This is referred to as the economies of scope.
Another motivator of merger is the possibility of having superior or more
efficient managerial employees. Mergers and acquisitions can pave way
for new more competent and capable managers replacing the present
inefficient ones.

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5. Possible Response To Government Policies

There are some government policies that require a particular size of a

company to operate and merger and acquisition can be a resolution to
this. There are also some governments that offer tax breaks and other
incentives to large firms, thus, encouraging the mergers and acquisitions
because if the tax liability is less then more profits will be generated.

6. Low Cost Of Capital

Cost of issuing equities subject to the economies of scale and

diversification out of merger results in lower cost of capital. Debt of the
combined firms becomes less risky because of its more stable income.
Creditors may ask for lower interest rate on their extended debts.

7. Bankruptcy Costs Reduction

Merger produce more wealth to the combined companies, thus, lowering

the possibility of bankruptcy and the numerous costs like firm’s selling
cost, legal expenses, and even opportunity cost due to possible delays in
legal processes.

8. Revenue Augmentation

Acquiring a company in a bullish market or even in a less competitive

condition can enrich revenues. An acquired firm that shows a different
credit, interest rate, and liquidity risk from the acquirer can result to a
more stable income.

Valuing a Merger

The most workable and dependable method being applied in evaluating the
profitability of a merger is the net present value (NPV) or the discounted
cash flow (DCF). The NPV method permits the acquirer and the target firm to
calculate the forecast of the cash flows of the combined firm and discount to
a present value based on its weighted average cost of capital (WACC). The
merged firm’s present value is then compared with the target firm’s
requested price to ascertain if the merger will be money-making one.

Merger Transactions Modes of Payment

There are some considerations to be taken into consideration before the
style or form of payment is adopted. These includes the risk ration shared by
the acquirer and the target firm in which the earlier is in the best position to
select, and the financial leverage of the acquirer. If it is highly leveraged, it is
not advisable that additional liabilities from the target firm will be assumed.
The different methods of payment in mergers and acquisitions are:
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1. Cash Purchase or Offering

The cash purchase simply involves the payment of cash. This can also be
assessed from a capital budgeting decision like purchasing a new plant or
leasing it.
Illustrative Problem 10.1
RST Corporation intends to acquire XYZ Company for P 1.5 million. The
expected cash flow of XYZ after tax earnings and depreciation of P200,
000 annually for 20 years. Combining the production facilities will yield a
synergistic benefit of an annual additional cash flow P 25,000. XYZ has a P
75,000 tax loss carry-forward that can be applied immediately by RST.
This will result to a tax shield on profit of P 24,000, assuming a tax rate of
32%. The present cost of capital of RST is 12% and this will be assumed
not to change with the acquisition.
Required: Compute the net present value or the amount to be paid by RST
to XYZ.

Solution:
Cash Outflows:
Purchase Price P1, 500,000
Less: Tax shield benefit 24,000
(P75, 000 x 32%) ----------------
Net Cash Outflow P 1,476,000
=========
Cash Inflows:
Cash inflows P 200,000
Add Synergistic benefits 25,000
Total cash inflows P 225,000
Present value of cash inflows:
P225, 000 x 7.469* P 1,680,525
*PVAF 20, 12%

The net present value of the investment:

Total PV of cash inflows P1, 680,525
Less: Net cash outflow 1,476,000
Net Present Value P 204,525
=========
This will conclude that the acquisition is desirable since it yields a
positive value of P 204,525.

2. Stock-For- Stock Purchase

A different approach giving emphasis on the earnings per share (EPS)’s
effect on the securities subject to the exchange will be used in the
analysis. The acquiring company’s notions and opinions will be
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considered in this approach. The shareholders of the target firm’s

concern are the initial price that they will be paid for their shares and the
position of the acquirer.

Illustrative Problem 10.2

Assuming ABS Corporation is planning of acquiring CBN Company. The
following information on the two firms prior to the merger is as follows:
ABS CBN
Total earnings P800, 000 P 250,000
Number of shares outstanding 150,000 100,000
EPS P 3.57 P 5.0
Price-earnings ratio 7 5
Market Price P 25.00 P 25.00

We will first assume that one ABS share to one CBN ratio with the same
market price will be traded. Also 100,000 shares of CBN will be involved.

Analysis:
The total earnings of ABS will be P1, 050,000 (ABS P800, 000 + CBN P250,
000)
The new number of outstanding shares for the surviving company will be
250,000 shares (ABS 150,000 plus CBN 100,000)
The new EPS for ABS will be P 4.20 (P1050, 000/250000 shares)
There is an increase in the EPS of ABS because the P/E ratio of ABS before
the merger is higher than CBN.
If ABS pays an amount higher to CBN current market price, then ABS
might be paying an equal or more than its (EPS) present P/E ratio.
There are numerous probabilities that might occur in the combination
based on the stock-for-stock exchange but the ultimate test of a successful
merger lies on the capabilities to enlarge the value of the acquiring firm.

3. Debt And Preferred Shares Financing

Acquiring companies must also think that not all investors prefer
increases in their shares; others want to received dividends or interest
income as the case maybe. So, management must be prepared in offering
a combination of securities to the new shareholders. Convertible
debentures and convertible preferred shares are frequently applied and
these have great impact on mergers and acquisitions.
Although the benefits of the convertible securities are decreasing due to
some requirements imposed by the accounting and securities profession,
there still remain some advantages that can be considered.
1. Possible earnings dilution may partially decrease by the issuance of
convertible securities.
2. Issuances of convertible securities may permit the acquirer to
conform to target firm or seller’s revenue objectives without altering
its dividend policy.
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3. The acquired firm may lessen its voting power by the issuance of
convertible preferred shares.
4. The convertible preferred stocks or debentures might be attractive to
the target firm because of it’s security protection combined with
growth potential of ordinary equity shares.

4. Deferred Payment Plan (DPP)

This mode of payment or sometimes called earn-out is the latest approach
to merger financing. This works when the acquirer agreed to make a
specific payment of cash or stock, and if it can retain or boost its earnings,
it will make additional payment.
Deferred payment scheme brings some benefits to the acquiring firm
such as:
a) It is a rational way of adjusting the difference between that number of
shares the buyer/acquirer is willing to issue and the amount of
seller/target firm will accept for the acquisition.
b) The acquiring company will be able to report a higher EPS because
few shares will be outstanding at the time of merger.
c) The acquirer is given the downside protection for totally not paying
the business to be acquired until the expected earnings have been
realized.

Despite the advantages of the DPP mentioned above, hypothetical

problems or issues must also be understood. These are:
a) The acquirer’s capability of an autonomous business operation to be
able to identify the target firm’s share to the total income.
b) There should be freedom of operation in the management of the
acquired firm’s business by the acquiring company.
c) The target firm’s willingness to contribute to the growth of the
acquiring company.

The type of DPP that will be used in our discussion and illustration in this
module is the base-period earn-out. This type will enable the shareholders of
the acquired company to receive additional shares for a specified number of
future years if the company improves its earnings above the base-period
earnings. The factors that will determine the amount of future payments are:
a) The amount of earnings in the future years in excess of the base-period
profits;
b) The parties agreed discount or capitalization rate;
c) The acquiring firm’s market value at the end of the each year.

The formula for shares payment in the future years is:

(Excess Earnings x Price /Earnings multiple) / The stock market value

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Illustrative Problem 10.3

GMA Company acquired ABC Corporation in 2015. ABC had a base-period
profit of P 500,000. At the time of the acquisition, ABC shareholders were
given 350,000 GMA shares. ABCs’ annual incomes prior to the merger are
P650, 000, P725, 000, P 750,000, and P 675,000. The market value of the
GMA’s share is P50 and the price/earnings ratio is 10.
Compute for the additional shares to be paid to ABC shareholders.
Solution:
Year 2016: [(P650, 000- P500, 000) x 10] / P50 = 30,000 shares
Year 2017: [(P725, 000- P500, 000) x 10] / P50 = 45,000 shares
Year 2018: [(P750, 000 – P500, 000) x 10] / P50 = 50,000 shares
Year 2019: [(P675, 000 – P500, 000) x 10] / P50 = 35,000 shares
Total 160,000 shares
===========
Conclusion: On top of the 350,000 GMA shares down payment ABC will be
receiving a total of 160,000 shares in the forthcoming years.
Our illustrative problem above is very simple. Please note that there other
factors or variables to be considered in developing a DPP. These are:
a) Specific limitation on the maximum amount of shares that can be
assigned in any one year.
b) A determined range of stock price utilized in the computation.
c) Proper recognition of the yearly increments in earnings over the previous
years.
d) Equitable down payment calculation.
e) A brief definition or description of earnings for the DPP purposes.
f) the continuing number of years in the DPP

Tender Offer
Tender Offer is an alternative approach in acquiring a company which has
been extensively recognized nowadays. How the tender offer works? An
interested party or company bids for controlling interest in another firm.
This interested company contacts the shareholders of the target firm and not
its management to persuade them to sell their shares at a premium (the
excess of the buying price over the current market price). Example: EBC
Corporation offered to buy 100,000 ordinary shares of LMN Corporation at P
20. Its current selling or market price is P 18.50.
Tender offer is a direct and precise appeal to the shareholders of the target
firm but the acquiring firm may choose to talk directly with its management.
A tender offer may be done if the bilateral management negotiations will fail.
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An unexpected takeover of the interested acquiring firm may happen without

communicating with management of the other company.

Ways to Resist Tender Offers

Tender offer is considered an unfriendly way of merger and acquisition. The
management of the target firm may neutralize this in different ways.
1. White Knight – A white knight is a firm that comes to the rescue of the
target company for a takeover.
2. PacMan – Named after a video game, this trick is characterized by the
situation that the target company becomes the acquirer.
3. Golden Parachute - This approach rules that the acquirer must
compensate the management of the target firm a huge amount of money
for an easy access as new management comes into the company.
4. Poison Pill – this involves an automatic action to be done if an interested
party attempts to purchase the firm.
5. Shark Repellants – In an attempt to discourage tender offeror, a target
firm may, for instance, do something like effecting changes in its bylaws
regarding the term of office of the directors so that few will come up for
election an any one year. This will delay the purchase of majority of the
existing board by the acquiring company.
6. Greenmail – This is a targeted repurchase, a defensive method applied to
save the target firm against a takeover after the bidder or acquiring firm
purchases a big number of shares in the open market and then attempts
to make a tender offer. The management of the target company who are
opposed to the takeover may offer the acquirer a sell-back of his acquired
shares to the corporation at a substantial amount, a price above the
market value.
7. Flip-over rights - the bylaws of a corporation may provide, to favor their
shareholders, a relatively bigger interest in an acquiring company in
exchange for their equity share.
8. Issuing equity rights – the target firm effect a significant increase in the
amount of outstanding equity share.
9. Reverse tender – a tender offer of the target corporation is made to effect
control of the acquiring company.
10. Crown Jewel transfer – the asset(s) that made the target firm a desirable
target is sold or dispose by the target corporation.
11. Legal action – One or more of the features of a tender offer may be
questioned by the target corporation in court.

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12. Fair-price provisions - Shareholders of the target firm may be issued

warrants to permit purchase of equity shares at a small percentage of the
current market price in case of takeovers.

Divestitures
Divestitures are essentially a way for a company to manage its portfolio of
assets. As companies grow, they may find that they are trying to focus on too
many lines of business, and they must close some operational units to focus
on more profitable lines. (Investopedia.com)
It is an important channel in changing the structure of a corporation to a
more efficient one. It eliminates a subsidiary or division that contributes less
to the firm’s basic goals.
Types of Divestitures
1. Sell-off – this is selling a subsidiary, product line, or division by a
company to another company.
2. Spin-off – This involves separating the subsidiary from its parent
company without changing the equity ownership. New shares for the
ownership in the divested assets are issued to the original shareholders
on a pro-rata basis.
3. Liquidation – This is not the shutting-down or dumping an asset. In this
case, the assets are sold to another firm and the proceeds are distributed
to the shareholders.
4. Going Private – this results when a publicly traded company is
purchased by a small group of investors and its shares is no longer sold
on public exchange.
5. Leverage buyout - This is a unique way of going private. The incumbent
shareholders sell their shares to a small group of investors who paid
them using their unused debt capacity in order to borrow money.
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References and Online Supplementaries

Book References

Brigham, Eugene, Houston, Joel (2012) fundamentals of Financial

Management, South-Western Cengage Learning, Ohio, USA.

Cabrera, Ma. Elenita Balatbat (2015) Financial Management, Principles and

Applications, Vol. 2. GIC Enterprises Co. Inc. Manila

Horngren, Charles T., Harrizon Jr., Walter T, & Bamber, Linda S. Accounting.
Fifth Edition. Prentice Hall International Edition

Medina, Roberto G. (2016 reprint) Business Finance. Rex Book Store, Manila.

Supplementary Reading Materials

Mergers & Acquisitions Lecture Notes

classes.bus.oregonstate.edu/.../PPT%20Lectures/Mergers%20and%20Acqui
sitions.ppt
Mergers & Acquisitions. BA 469. Prof. Dowling. Spring Term, 2007. Mergers
& Acquisitions. M & A's are the quickest route companies have to new
markets and ...
Accessed: November 6, 2017

Lecture Series Mergers and Acquisitions

https://www.vse.cz/hostujici-
profesori/1FP580_Mergers_and_Acquisitions_2007.pdf
Lecture Series. Mergers and Acquisitions. December, 2007. Unit of Study
Outline. Coordinator: Senior Lecturer Dr P. Joakim Westerholm. Phone: TBA,
Email: ...
Accessed: November 6, 2017

[PPT]Mergers and Acquisitions - Yale School of Management

som.yale.edu/~spiegel/mgt541/Lectures/MergersandAcquisitions.ppt

Course Module
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Mergers and Acquisitions; Divestitures

Mergers and Acquisitions. Good But for Who? What is a Merger? In a

MERGER, two (or more) corporations come together to combine and share
their resources ...
Accessed: November 6, 2017

Lecture Notes | The Law of Mergers and Acquisitions | Sloan School of

https://ocw.mit.edu/courses/sloan...of...mergers-and-acquisitions.../lecture-
notes/
Class #, Topics. Module I - An Overview of Fundamentals. 1, An Overview of
Key Players, Their Legal Responsibilities and Early Roles. 2 and 3, Tax ...
Accessed: November 6, 2017

Supplementary Online Videos

Mergers and acquisitions - YouTube

https://www.youtube.com/watch?v=yLyUVNkbQcc
Jul 20, 2014 - Uploaded by Audiopedia
Mergers and acquisitions (abbreviated M&A) are both aspects of strategic
management, corporate finance and ...
Accessed: November 6, 2017

R27 Mergers and Acquisitions Lecture 1 CMA - YouTube

https://www.youtube.com/watch?v=ipIscUnIy14
Nov 13, 2016 - Uploaded by Mohammad Lutfor Rahaman khan
Accessed: November 6, 2017