MERGERS AND ACQUISITIONS

LEARNING OUTCOMES

• Differentiate Mergers and

acquisitions
• Distinguish the types of
acquisition
• Differentiate between
hostile and friendly
mergers
• Discuss the classification of
mergers
• Explain the rationale for
mergers
MERGERS AND ACQUISITIONS

• The phrase mergers and acquisitions

(abbreviated M&A) refers to the aspect of
corporate strategy, corporate finance and
management dealing with the buying, selling
and combining of different companies that
can aid, finance, or help a growing company in
a given industry grow rapidly without having to
create another business entity.
Consolidation

•Combination in which all the

combining companies are
dissolved and a new firm is
formed
ACQUISITION
• An acquisition, also known as a takeover, is the
buying of one company (the ‘target’) by another.
• An acquisition may be friendly or hostile.
• Friendly-the companies cooperate in
negotiations;
• Hostile- the takeover target is unwilling to be
bought or the target's board has no prior
knowledge of the offer.
• Acquisition usually refers to a purchase of a
smaller firm by a larger one.
• Sometimes, however, a smaller firm will acquire
management control of a larger or longer
established company and keep its name for the
combined entity.
• This is known as a reverse takeover
 TYPES OF ACQUISITION

• STOCK PURCHASE
• The buyer buys the shares, and therefore control, of the target
company being purchased.
• Company stays intact
• Includes all assets and liabilities
• ASSET PURCHASE
• The buyer buys the assets of the target company.
• Cash is used to pay of shareholders
• Company becomes an “empty shell”
MERGER
• a merger is a combination of two companies into one
larger company.
• Such actions are commonly voluntary and involve stock
swap or cash payment to the target.
• Stock swap is often used as it allows the shareholders of
the two companies to share the risk involved in the deal.
MERGER
• A merger can resemble a takeover but result in a
new company name (often combining the names of
the original companies) and in new branding;
• in some cases, terming the combination a "merger"
rather than an acquisition is done purely for
political or marketing reasons.
CLASSIFICATIONS OF MERGERS

• Horizontal mergers take place where the two

merging companies produce similar product in the
same industry.
• Vertical mergers occur when two firms, each
working at different stages in the production of the
same good, combine.
• Concentric mergers occur where two merging
firms are in the same general industry, but they
have no mutual buyer/customer or supplier
relationship, such as a merger between a bank and
a leasing company. Example: Prudential's
acquisition of Bache & Company.
• Conglomerate mergers take place when the two
firms operate in different industries.
 TYPES OF MERGERS ACCORDING TO EFFECTS
ON EPS
• Accretive mergers are those in which an acquiring
company's earnings per share (EPS) increase. An
alternative way of calculating this is if a company
with a high price to earnings ratio (P/E) acquires one
with a low P/E.
• Dilutive mergers are the opposite of above, whereby
a company's EPS decreases. The company will be one
with a low P/E acquiring one with a high P/E.
DISTINCTION BETWEEN MERGERS AND
ACQUISITIONS

• When one company takes over another and

clearly established itself as the new owner,
the purchase is called an acquisition.
• From a legal point of view, the target
company ceases to exist, the buyer "swallows"
the business and the buyer's stock continues
to be traded.
DISTINCTION BETWEEN MERGERS AND
ACQUISITIONS
• A MERGER happens when two firms, often of about the
same size, agree to go forward as a single new company
rather than remain separately owned and operated.
• This kind of action is more precisely referred to as a
"merger of equals".
• Both companies' stocks are surrendered and new company
stock is issued in its place. For example, both Daimler-Benz
and Chrysler ceased to exist when the two firms merged,
and a new company, DaimlerChrysler, was created.
DISTINCTION BETWEEN MERGERS AND
ACQUISITIONS

• Whether a purchase is considered a merger or an

acquisition really depends on whether the
purchase is friendly or hostile and how it is
announced.
• In other words, the real difference lies in how the
purchase is communicated to and received by the
target company's board of directors, employees
and shareholders.
Five Largest completed and proposed
mergers, as of January 2000

Buyer Target Value

America Online Time Warner $160.0 billion
Vodafone AirTouch Mannesmann 148.6 billion
MCI WorldCom Sprint 128.9 billion
Exxon Mobil 85.2 billion
Bell Atlantic GTE 85.0 billion
Differentiate between hostile and
friendly mergers

• Friendly merger:
• The merger is supported by the managements of both
firms.
MOTIVES BEHIND M&A
• Synergy: This refers to the fact that the combined
company can often reduce its fixed costs by
removing duplicate departments or operations,
lowering the costs of the company relative to the
same revenue stream, thus increasing profit
margins.
MOTIVES BEHIND M&A

• Increased revenue or market share: This

assumes that the buyer will be absorbing a
major competitor and thus increase its
market power (by capturing increased market
share) to set prices.
MOTIVES BEHIND M&A

• Cross-selling: For example, a bank buying a stock

broker could then sell its banking products to the
stock broker's customers, while the broker can sign
up the bank's customers for brokerage accounts.
Or, a manufacturer can acquire and sell
complementary products.
MOTIVES BEHIND M&A

• Economy of scale: For example, managerial economies

such as the increased opportunity of managerial
specialization. Another example are purchasing
economies due to increased order size and associated
bulk-buying discounts.
• Taxation: A profitable company can buy a loss maker to
use the target's loss as their advantage by reducing their
tax liability.
 MOTIVES BEHIND M&A

• Geographical or other diversification: This is designed

to smooth the earnings results of a company, which over
the long term smoothens the stock price of a company,
• Resource transfer: resources are unevenly distributed
across firms (Barney, 1991) and the interaction of target
and acquiring firm resources can create value through
either overcoming information asymmetry or by
combining scarce resources
 Reasons why alliances can make more
sense than acquisitions
• Access to new markets and technologies
• Multiple parties share risks and expenses
• Rivals can often work together harmoniously
• Antitrust laws can shelter cooperative R&D activities
HOSTILE TAKEOVERS
DEFENSE TACTICS

• CORPORATE CHARTER
• Provisions to make takeovers more difficult
• GREENMAIL
• Arranged targeted repurchase from buyers
• EXCLUSIONARY SELF-TENDERS
• Offers own stocks but excludes targeted stockholders
• LEVERAGED BUYOUTS
• Bought by existing management ( off the market)
GOLDEN
PARACHUTE

• Top executives
receive high
termination
payments
MERGER ANALYSIS

• ACQUIRING FIRM
• PERFORMS ANALYSIS TO VALUE THE TARGET FIRM
• DETERMINE IF TARGET CAN BE BOUGHT AT THAT
VALUE OR PREFERABLY FOR LESS
• TARGET FIRM
• ACCEPTS THE OFFER IF THE PRICE EXCEEDS ITS VALUE
IF IT CONTINUES TO OPERATE INDEPENDENTLY
STEPS
• VALUING THE TARGET FIRM
• USE OF CAPITAL BUDGETING TECHNIQUES
• CASH FLOW ANALYSIS AND NPV
• SETTING THE BID PRICE
• POST-MERGER CONTROL
VALUING THE TARGET FIRM

• CASH FLOW ANALYSIS

• NPV
 2009 2010 2011 2012 2013
Net sales 105 126 151 174 191
Less COGS 75 89 106 122 132
Less Operating 10 12 13 15 16
expense
Less Depreciation 8 8 9 9 10
EBIT 12 17 23 28 33
Less INTEREST 8 9 10 11 11
EBT 4 8 13 17 22
Less 40% tax 1.6 3.2 5.2 6.8 8.8
NET INCOME 2.4 4.8 7.8 10.2 13.2
Plus 8 8 8 9 10
depreciation
CASH FLOW 10.4 12.8 16.8 19.2 23.2
Less retention 4 4 7 9 12
Plus terminal value 127.8

NET CASH FLOW 6.4 8.8 9.8 10.2 139

 Conceptually, what is the appropriate
discount rate to apply to target’s
cash flows?

• Estimated cash flows are residuals which belong to

acquirer’s shareholders.
• They are riskier than the typical capital budgeting
cash flows.
• Because fixed interest charges are deducted, this
increases the volatility of the residual cash flows.
(More...)
• Because the cash flows are risky equity flows, they
should be discounted using the cost of equity
rather than the WACC.
• The cash flows reflect the target’s business risk,
not the acquiring company’s.
• However, the merger will affect the target’s
leverage and tax rate, hence its financial risk.
 Terminal Value Calculation

1. First, find the new discount rate:

ks(Target) = kRF + (kM – kRF)bTarget
= 6% + (5%)1.63 = 14.2%.
(2013 Cash flow)(1 + g)
2. Terminal value= ks –g
$(23.2-12)(1.06)
= – 0.05
0.142

= $127.7.0 million.
 2009 2010 2011 2012 2013
CASH FLOW 10.4 12.8 16.8 19.2 23.2
Less retention 4 4 7 9 12

Plus terminal 127.8

value

NET CASH FLOW 6.4 8.8 9.8 10.2 139

VALUE = sum of the present values of the NCFs

Value= $96.5
 Would another acquiring company obtain
the same value?
• No. The input estimates would be different, and
different synergies would lead to different cash flow
forecasts.
• Also, a different financing mix or tax rate would
change the discount rate.
Target firm has 10 million shares
outstanding at a price P0 of $6.25 per
share. What should the offering
price be?

Value of Acquisition
Maximum price = Shares Outstanding
$96.5 million
= 10 million
= $9.65/share.
.
• The offer could range from $6.25 to $9.65 per share.
• At $6.25 all the merger benefits would go to the
acquirer’s shareholders.
• At $9.65, all value added would go to the target’s
shareholders.
• See graph on the next slide.
Change in
Shareholders’
Wealth
Acquirer Target

$6.25 $9.65
Price
Paid for
0 6 8 10 12 Target
Bargaining Range =
Synergy
 Points About Graph

• Nothing magic about crossover price.

• Actual price would be determined by bargaining. Higher
if target is in better bargaining position, lower if acquirer
is.
• If target is good fit for many acquirers, other firms will
come in, price will be bid up. If not, could be close to
$6.25.

(More...)
• Acquirer might want to make high
“preemptive” bid to ward off other
bidders, or low bid and then plan to go
up. Strategy.
• Do target’s managers have 51% of stock
and want to remain in control?
• What kind of personal deal will target’s
managers get?
 Do mergers really create value?

• The evidence strongly suggests:

• Acquisitions do create value as a result of economies of
scale, other synergies, and/or better management.
• Shareholders of target firms reap most of the benefits,
i.e., move to right in merger graph (Slide 21-17),
because of competitive bids.
 Functions of Investment Bankers in
Mergers

• Arranging mergers
• Assisting in defensive tactics
• Establishing a fair value
• Financing mergers
• Risk arbitrage