Chapter

29

Mergers and Acquisitions

Copyright 2015 by the McGraw-Hill Education (Asia). All rights reserved.

Key Concepts and Skills

Be able to define the various terms associated with
M&A activity
Understand the various reasons for mergers and
whether or not those reasons are in the best interest
of shareholders
Understand the various methods for paying for an
acquisition
Understand the various defensive tactics that are
available

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Chapter Outline
29.1 The Basic Forms of Acquisitions
29.2 Synergy
29.3 Sources of Synergy
29.4 Dubious Reasons for Acquisitions
29.5 A Cost to Stockholders from Reduction in Risk
29.6 The NPV of a Merger
29.7 Friendly versus Hostile Takeovers
29.8 Defensive Tactics
29.9 Do Mergers Add Value?
29.10 The Tax Forms of Acquisitions
29.11 Accounting for Acquisitions
29.12 Going Private and Leveraged Buyouts
29.13 Divestitures
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29.1 The Basic Forms of Acquisitions

There are three basic legal procedures that

one firm can use to acquire another firm:

Merger or Consolidation
Acquisition of Stock
Acquisition of Assets

29-4

Merger versus Consolidation

Merger
One firm is acquired by another
Acquiring firm retains name and acquired firm ceases
to exist
Advantage legally simple
Disadvantage must be approved by stockholders of
both firms

Consolidation

Entirely new firm is created from combination of

existing firms
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Acquisitions

A firm can be acquired by another firm or individual(s)

purchasing voting shares of the firms stock
Tender offer public offer to buy shares
Stock acquisition

No stockholder vote required

Can deal directly with stockholders, even if management is unfriendly
May be delayed if some target shareholders hold out for more money
complete absorption requires a merger

Classifications

Horizontal both firms are in the same industry

Vertical firms are in different stages of the production process
Conglomerate firms are unrelated
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Varieties of Takeovers
Merger

Takeovers

Acquisition

Acquisition of Stock

Proxy Contest

Acquisition of Assets

Going Private
(LBO)

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29.2 Synergy

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 are not 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.

29-8

Synergy

Suppose firm A is contemplating acquiring firm B.

The synergy from the acquisition is
Synergy = VAB (VA + VB)
The synergy of an acquisition can be determined
from the standard discounted cash flow model:

Synergy =

t=1

CFt
(1 + R)t
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29.3 Sources of Synergy

Revenue Enhancement
Cost Reduction

Tax Gains

Replacement of ineffective managers

Economy of scale or scope
Net operating losses
Unused debt capacity

Incremental new investment required in

working capital and fixed assets
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Calculating Value

Avoiding Mistakes

Do not ignore market values

Estimate only Incremental cash flows
Use the correct discount rate
Do not forget transactions costs

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29.4 Dubious Reasons for Acquisitions

Earnings Growth

If there are no synergies or other benefits to the

merger, then the growth in EPS is just an artifact of a
larger firm and is not true growth (i.e., 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.
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29.5 A Cost to Stockholders from

Reduction in Risk

The Base Case

Both Firms Have Debt

If two all-equity firms merge, there is no transfer of

synergies to bondholders, but if
The value of the levered shareholders call option falls.

How Can Shareholders Reduce their Losses from

the Coinsurance Effect?

Retire debt pre-merger and/or increase post-merger debt

usage.
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29.6 The NPV of a Merger

Typically, a firm would use NPV analysis

when making acquisitions.
The analysis is straightforward with a cash
offer, but it gets complicated when the
consideration is stock.

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Cash Acquisition

The NPV of a cash acquisition is:

NPV = (VB + V) cash paid = VB* cash paid

Value of the combined firm is:

VAB = VA + (VB* cash paid)

Often, the entire NPV goes to the target firm.

Remember that a zero-NPV investment may
also be desirable.

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Stock Acquisition

Value of combined firm

Purchase price of acquisition

VAB = VA + VB + V

Depends on the number of shares given to the target

stockholders
Depends on the price of the combined firms stock after the
merger

Considerations when choosing between cash and stock

Sharing gains target stockholders do not participate in stock

price appreciation with a cash acquisition
Taxes cash acquisitions are generally taxable
Control cash acquisitions do not dilute control
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29.7 Friendly vs. Hostile Takeovers

In a friendly merger, both companies

management are receptive.
In a hostile merger, the acquiring firm
attempts to gain control of the target without
their approval.

Tender offer
Proxy fight

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29.8 Defensive Tactics

Corporate charter
Classified board (i.e., staggered elections)
Supermajority voting requirement

Golden parachutes
Targeted repurchase (a.k.a. greenmail)
Standstill agreements
Poison pills
Leveraged buyouts

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More (Colorful) Terms

Poison put
Crown jewel
White knight
Lockup
Shark repellent
Bear hug
Fair price provision
Dual class capitalization
Countertender offer
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29.9 Do Mergers Add Value?

Shareholders of target companies tend to earn excess

returns in a merger:

Shareholders of target companies gain more in a tender

offer than in a straight merger.
Target firm managers have a tendency to oppose mergers,
thus driving up the tender price.

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Do Mergers Add Value?

Shareholders of bidding firms earn a small excess

return in a tender offer, but none in a straight merger:

Anticipated gains from mergers may not be achieved.

Bidding firms are generally larger, so it takes a larger
dollar gain to get the same percentage gain.
Management may not be acting in stockholders best
interest.
Takeover market may be competitive.
Announcement may not contain new information about
the bidding firm.

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29.10 The Tax Forms of Acquisition

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.

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29.11 Accounting for Acquisitions

The Purchase Method

Assets of the acquired firm are reported at their

fair market value.
Any excess payment above the fair market value
is reported as goodwill.
Historically, goodwill was amortized. Now it
remains on the books until it is deemed
impaired.

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29.12 Going Private and Leveraged

Buyouts
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
previous managers into owners.
This reduces the agency costs of equity.

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29.13 Divestitures
Divestiture company sells a piece of itself to
another company
Equity carve-out company creates a new
company out of a subsidiary and then sells a
minority interest to the public through an IPO
Spin-off company creates a new company
out of a subsidiary and distributes the shares of
the new company to the parent companys
stockholders

29-25

Quick Quiz

What are the different methods of achieving a takeover?

How do we account for acquisitions?
What are some of the reasons cited for mergers? Which
of these may be in stockholders best interest and which
generally are not?
What are some of the defensive tactics that firms use to
thwart takeovers?
How can a firm restructure itself? How do these
methods differ in terms of ownership?
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