Mergers and Acquisitions

Mergers and Acquisitions
Chapter 11
Krishna G. Palepu, Paul M. Healy and Erik Peek, Business Analysis and Valuation: 5th IFRS Edition
© Copyright Cengage Learning EMEA 2019
MOTIVATIONS FOR MERGER OR ACQUISITION
• There are a number of reasons why a firm may choose to merge with
or acquire another one, including:
– Economies of scale
– Improving target management
– Combining complimentary resources
– Capturing tax benefits
MOTIVATIONS FOR MERGER OR ACQUISITION, CONTINUED
• Providing low-cost financing to target
• Creating value through restructuring and breakups
• Penetrating new markets
• Increasing product-market rents
• Diversification
MOTIVATION FOR THE DUPONT-DANISCO MERGER
• The DuPont–Danisco merger serves as a great real-life example to

examine some of the issues related to M&A.
• Motivation for the merger:
– Eliminating duplicate functions and reducing R&D costs

– Combining DuPont’s strength in biomass processing and microbe
engineering with Danisco’s strength in manufacturing enzymes
– Benefiting from Danisco’s strong sales organization
– No immediate effects on product market rents, target management
or tax
ACQUISITION PRICING
• It is crucial for the analyst to determine the appropriate price to pay for
the target firm. Following are the methods used:
• Analyzing premium offered to target shareholders
– One popular way is through comparisons of similar transactions,

though this may be difficult.
• Comparable transactions are difficult to define
• Degrees of investor anticipation of the event may drive the
premium
ACQUISITION PRICING, CONTINUED
• Analyzing value of the target to the acquirer, a second and more

reliable method.
• Earnings multiples:
– Forecasting earnings
• Compare with and without merging companies
– Determining the price-earnings multiple
• Both pre- and post-merger forward PE multiples are
possibilities
– Limitations of price-earnings valuation
• PE models focus on immediate increases in earnings or
earnings growth, but do not easily incorporate all benefits
ACQUISITION PRICING, CONTINUED
• Discounted abnormal profits or cash flows
– Forecasting abnormal profits/free cash flows

• Assume the target is standalone, as a starting point
• Improvements in profits/free cash flows can then be
incorporated
– Compute the discount rate
• Use post-acquisition cost of equity or required return on
operating assets, not pre-acquisition
– Sensitivity analysis
• Questions may include
– What if the acquisition takes longer than anticipated?
– What if competitors respond with their own M&A?
DUPONT’S PRICING OF DANISCO
• Cash tender offer: affects the premium
• DuPont’s bid price represented a 29% premium to target shareholders:

– Average premium in cash financed acquisitions: 25%
• Traditional multiples-based valuation suggests that the bid was on the

low side, signaling that management may expect that the synergy
effect will not persist or is uncertain.
• Initial market reactions were negative; after the announcement,

DuPont’s stock price was down 1.5%.
ACQUISITION FINANCING AND FORM OF PAYMENT
• The form of payment is an important financing decision.
– Capital structure effects

• If debt financing is used, analysis should be conducted to see if
the increase in financial leverage is excessive.
– Information problems
• Asymmetric information levels between management and
shareholders may cause investors to misinterpret the form of
financing.
– Control and the form of payment

• Using stock to finance M&A dilutes the ownership and control
of the acquiring firm.
ACQUISITION FORM OF PAYMENT
• Effect of form of payment on target stockholders
– Tax effects
• Cash received by target shareholders triggers capital gain
(loss) recognition, while receiving shares of the acquiring firm
defers recognition of gain (loss).
– Transaction costs
• Incurred when target stockholders sell stock received under
consideration for their shares in the target
• If the bidder offers cash, target stockholders won’t face these
costs.
• Not significant for investors planning to hold acquirer’s stock
following the acquisition.
ACQUISITION OUTCOME
• Another consideration should be whether the transaction will be

completed.
– Other potential acquirers

• Others may offer a higher bid
– Target management entrenchment

• Target management may fear losing their jobs
– Antitrust and securities issues
PURCHASE PRICE ALLOCATION
• The International Financial Reporting Standard on Business

Combinations requires that acquirers separately identify and value
assets acquired and liabilities assumed in an M&A.
– This process is called the purchase price allocation
• Steps in a purchase price allocation are:
1. Determine the value of the target firm

2. Estimate the rate of return implicit in the M&A transaction
3. Identify the contributory assets: separately identifiable assets that
contribute to the post-acquisition cash flows of the target firm
4. Value the contributory assets
5. Calculate and evaluate goodwill
VALUATION METHODS IN A PURCHASE PRICE ALLOCATION
• Cost approach
– Least preferred approach
• Market approach
– Most appropriate for frequently traded assets
• Income approach
– Direct cash flow forecast method
• Especially useful for financial assets
– Relief-from-royalty method
• Especially useful for brands, patents, technology
– Multi-period excess earnings method
• Especially useful for customer relationships
DUPONT-DANISCO PURCHASE PRICE ALLOCATION
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CONCLUDING COMMENTS
• There are many motivations for firms to merge with or acquire others.
• It is important to assess whether a merger or acquisition creates value for the

acquiring firms’ shareholders.
• Valuation tools learned in prior chapters may be employed in determining a

reasonable price for a target firm.

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– Improving target management

– Combining complimentary resources

– Capturing tax benefits

• Providing low-cost financing to target

• Creating value through restructuring and breakups

• Penetrating new markets

• Increasing product-market rents

• The DuPont–Danisco merger serves as a great real-life example to

• Motivation for the merger:

– Eliminating duplicate functions and reducing R&D costs

• Analyzing premium offered to target shareholders

– One popular way is through comparisons of similar transactions,

• Analyzing value of the target to the acquirer, a second and more

• Discounted abnormal profits or cash flows

– Forecasting abnormal profits/free cash flows

• Cash tender offer: affects the premium

• DuPont’s bid price represented a 29% premium to target shareholders:

• Traditional multiples-based valuation suggests that the bid was on the

• Initial market reactions were negative; after the announcement,

• The form of payment is an important financing decision.

– Capital structure effects

– Control and the form of payment

• Effect of form of payment on target stockholders

• Another consideration should be whether the transaction will be

– Other potential acquirers

– Target management entrenchment

– Antitrust and securities issues

• The International Financial Reporting Standard on Business

• Steps in a purchase price allocation are:

1. Determine the value of the target firm

• It is important to assess whether a merger or acquisition creates value for the

• Valuation tools learned in prior chapters may be employed in determining a

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