Chapter 19
Analysis of Takeovers
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-1
Learning Objectives
• Understand and evaluate suggested reasons for
takeovers.
• Explain how to estimate the gains and costs of
takeovers.
• Explain the main differences between cash and shareexchange takeovers.
• Outline the regulation and tax effects of takeovers in
Australia.
• Outline defence strategies that can be used by target
companies.
• Identify the various types of corporate restructuring
transactions.
• Outline the main findings of empirical research on the
effects of takeovers on shareholders’ wealth.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-2
Fundamental Concepts
• Takeovers typically involve one company
purchasing another by acquiring a controlling
interest in its voting shares.
• Also called ‘acquisitions’ and ‘mergers’.
• Takeovers involve changes in the ownership of
assets.
• No simple explanation for the existence of
takeover ‘waves’:
– Evidence that takeover activity is positively related to
the behaviour of share prices.
– Periods when share prices are increasing are also
periods of optimism for investment.
– While companies will increase internal investment, they
will also look for external investment (opportunities to
take control of existing assets).
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-3
Types of Takeovers
• Horizontal takeover: takeover of a target company
operating in the same line of business as the
acquiring company.
• Vertical takeover: takeover of a target company
that is either a supplier of goods to, or a consumer
of goods produced by, the acquiring company.
• Conglomerate takeover: takeover of a target
company in an unrelated type of business.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-4
Reasons for Takeovers
• Synergy in takeovers is the situation where the
performance, and therefore the value, of a
combined entity exceeds those of the previously
separate components:
– The target company is managed inefficiently and is
undervalued.
– The acquiring and target companies have assets that are
complementary.
– Results in cost reductions, increased market power,
diversification benefits, and tax benefits.
– The target company or the acquiring company has excess
liquidity or free cash flow.
– There are increased earnings per share and price–
earnings ratio effects.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-5
Evaluation of the Reasons for
Takeovers
• The target company is managed inefficiently:
– Managers may be inefficient and acting in their own
interest rather than shareholders’, thereby reducing
market value and inducing takeover offers.
• Complementary assets:
– Sometimes either or both of the companies can provide
the other with needed resources at relatively low cost.
• Cost reductions:
– Cost savings may be due to economies of scale.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-6
Evaluation of the Reasons for
Takeovers (cont.)
• Target company is undervalued:
– A takeover may also occur when the market value of the
target company is less than the sum of the market values
of its assets.
• Increased market power:
– Taking over a company in the same industry may
increase the market power of the combined company.
• Diversification benefits:
– The takeover, it is suggested, enables a company to
reduce risk via diversification.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-7
Evaluation of the Reasons for
Takeovers (cont.)
• Excess liquidity and free cash flow:
– A company with excess liquidity may be identified as a
takeover target by companies seeking access to funds.
• Tax benefits:
– Taking over a company with accumulated tax losses may
reduce the total tax payable by the combined company
• Increased earnings per share (EPS) and price–
earnings ratio effects:
– While acquiring companies may wish to evaluate the effect
of a proposed takeover on their EPS, this is an unreliable
approach. It is quite possible that a takeover that produces
no economic benefits will nevertheless produce an
immediate increase in EPS (bootstrapping).
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-8
Economic Evaluation of Takeovers
• Takeovers can take advantage of synergies such as
economies of scale or complementarity between assets.
• The gain from the takeover can be defined as the difference
between the value of the combined company and the sum of
their values as independent entities:
Gain  VAT  VA  VT 
• Assuming that cash is used to buy Company T, the net cost is
defined as:
Net Cost  Cash  VT
–
Cost is considered in terms of the premium paid over T’s
value as an independent entity.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-9
Economic Evaluation of Takeovers
(cont.)
•
The takeover will have a positive NPV for Company A’s shareholders
only if the gain exceeds the net cost:
NPVA  gain - net cost
 gain - cash+VT  0
•
•
If NPVA is equal to zero, then the above equation can be used to find
the value of Company T to Company A, VT(A), which is the maximum
price A should pay for the target:
VT  A  cash = gain+VT
It is necessary to focus on the incremental cash flow effects of the
takeover:
– Incremental inflows.
– Incremental outflows.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-10
Comparing Gains and Costs
• The amount of the cash consideration determines
how the total gain is divided between the two sets of
shareholders.
• Every additional dollar paid to the target’s
shareholders means a dollar less for the acquirer’s
shareholders.
• Note that the possible gains from a takeover may
already be impounded into the target’s market price.
– Management should, therefore, check that the share price
of a proposed target has not already been increased by
takeover rumours.
– Management should also keep their takeover intentions
completely confidential until formally announcing the bid.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-11
Estimating Cost for a ShareExchange Takeover
•
Share-exchange takeover: acquiring company issues shares in
exchange for the target’s shares.
•
The cost will depend on the post-takeover price of the acquiring
company’s shares.
Net cost  b VAT  VT
where:
b  the fraction of the combined company
that will be owned by the former
shareholders of the target company
•
For a cash offer, the net cost is independent of the takeover gain,
whereas for a share-exchange offer, the cost depends on the takeover
gain.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-12
Regulation of Takeovers
• The main legislation is Chapter 6 of the Corporations Act
2001.
• Australian Securities and Investments Commission (ASIC)
administers the Corporations Act.
• ASIC has some discretion and can apply to the Takeovers
Panel if an acquisition is believed to be inappropriate.
• The most important aspect of the Corporations Act is that
unless the procedures laid down in Chapter 6 are
followed, the acquisition of additional shares in a company
is virtually prohibited if this would:
– Result in a shareholder being entitled to more than 20% of
the voting shares or increase the voting shares held by a
party that already holds 20–90% of the voting shares of the
company.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-13
Regulation of Takeovers
(cont.)
• Different regulations of takeovers are:
– Off-Market Bid.
– Market Bids.
– Disclosure Requirements.
– Creeping Takeover.
– Partial Takeover.
– Schemes of Agreement.
– Tax Effect of Takeover.
– Break Fees, Takeovers and Corporate Governance.
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19-14
Other Controls on Takeovers
• Legislation other than the Corporations Act may
affect takeovers:
– Trade Practices Act — competition.
– Foreign Acquisitions and Takeovers Act — Federal
Treasurer has the power to prohibit takeovers by foreign
companies — for example Shell and Woodside (2001).
– Industry-related legislation — media ownership laws,
four pillars banking policy.
• ASX listing rules — secrecy during takeover
discussions, or apply for trading halt, shares cannot
be placed (via a private placement) for 3 months
after receiving a takeover offer.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-15
Takeover Defences
• Takeovers Panel — decisions on takeovers
should be made by shareholders.
• Takeover defence should be in interests of
shareholders.
• Defence measures are of two basic types:
– Pre-emptive measures aimed as discouraging bids.
– Strategies employed after a bid is received.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-16
Takeover Defences (cont.)
• Different characteristics of takeover defences are:
– Poison pills.
– Acquisition by friendly parties.
– Disclosure of favourable information.
– Claims and appeals.
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19-17
Takeover Defences (cont.)
• Effects of takeover defences:
– Directors are faced with a conflict of interest.
– It is also important that management ensure that their
recommendation is consistent with their responsibilities
to shareholders.
– Resistance can extract additional value for shareholders
but can be in interests of directors maintaining position.
– Empirical evidence suggests worst managers are most
likely to resist — hard to find a new job.
– Even pay packages with termination packages in the event
of takeover may not work — directors may recommend a
low takeover to get payout.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-18
Corporate Restructuring
• Divestitures:
– Involve assets, which may be a whole subsidiary,
being sold for cash.
– It is essentially a reverse merger from the point of
view of the seller.
– Divestitures create value for the shareholders of
selling companies:
 The assets transferred must be more valuable to the
buyer than the seller.
 The selling company may also benefit by the removal
of a unit that was managed poorly, or that had created
diseconomies of scale.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-19
Corporate Restructuring (cont.)
• Spin-offs:
– A single organisational structure is replaced by two
separate units under essentially the same ownership.
– US research has found significant positive market
reaction to spin-offs.
– Likely explanations are gains from:
 Simplifying a complex conglomerate structure.
 Decentralising decision making.
 Motivating management more effectively.
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19-20
Corporate Restructuring (cont.)
• Buyouts:
– Involve a transfer from public to private ownership of a
company through the purchase of its shares by a small
group of investors.
– A buyout or going private transaction can take
several forms:
 Management buyout: purchase of all of a company’s
issued shares by a group led by the company’s
management.
 Leveraged buyout: takeover of a company that is largely
financed using borrowed funds — the remaining equity is
privately held by a small group of investors.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-21
Empirical Evidence on
Takeovers: Target Company
• Target company shareholders earn significant
positive abnormal returns:
– Brown and da Silva Rosa (1997): average abnormal
return of 25.5% over the 7-month period around the
takeover announcement.
– Casey, Dodd and Dolan (1987) reported significant
abnormal returns on target company shares around the
time that significant shareholding notices were filed.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-22
Empirical Evidence on
Takeovers: Target Company
(cont.)
• The initial increase in wealth of the target
company’s shareholders appears to be
maintained, even where the bid is unsuccessful.
– The bid may have prompted a change in the target
company’s investment strategy, which is expected to
improve performance.
– Information released during the bid caused the market to
revalue the shares.
– The market may expect a further bid for the target
company.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-23
Empirical Evidence on
Takeovers: Acquiring
Company
• On average, the shareholders of acquiring
companies earn positive abnormal returns in the
years before the takeover bid is made.
• This suggests that takeover bids are typically made
by companies that have been doing well, and have
demonstrated an ability to manage assets and
growth.
• Many studies have found that around the time of the
announcement, the average abnormal returns to
shareholders of bidding companies is close to zero
and, in some cases, negative.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-24
Empirical Evidence on
Takeovers: Acquiring
Company (cont.)
• Jarrell and Poulsen (1989) identified three general
explanations for the negligible wealth effects for
acquiring company shareholders:
– Takeovers are profitable, but the wealth effects are
disguised.
– Competition depresses returns to acquirers.
– Takeovers are neutral or poor investments.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-25
Empirical Evidence on
Takeovers: Acquiring
Company (cont.)
• The wealth effects of takeovers are disguised:
– An acquiring company is typically much larger than a
target company, so while there may be a worthwhile
dollar gain to shareholders, the gain is small relative to
the total value of the company.
– When a company has a known strategy of growth by
acquisition, the expected gains from this strategy may
already be reflected in the company’s share price.
– Announcement effects that are small or negative
may also reflect market reaction to the financing of
the takeover.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-26
Empirical Evidence on
Takeovers: Acquiring
Company (cont.)
• Competition depresses returns to acquirers:
– Returns to successful bidders are likely to be lower if a
takeover is resisted by target management, or contested by
multiple bidders.
– Returns to acquiring companies when there are multiple
bidders are insignificantly different from zero.
– Returns to acquiring companies when there is only one
bidder are significantly positive.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-27
Empirical Evidence on
Takeovers: Acquiring
Company (cont.)
• Takeovers are neutral or poor investments:
– Roll’s hubris hypothesis — managers of acquiring
companies are supremely confident that their ability to value
other companies is better than that of the market.
– Consequently, they pay more for companies than they are
worth.
– The large returns to target shareholders represent wealth
transfers from the shareholders of acquiring companies.
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19-28
Empirical Evidence on
Takeovers: Are Takeovers Poor
Investments?
• Bradley, Desai and Kim (1988)
– Found an average gain of $117m, or 7.4%, in the combined
wealth of shareholders.
– Their results support the hypothesis that takeovers yield
real, synergistic gains and do not support Roll’s ‘wealth
transfer’ hypothesis. However, they found that for some
types of acquisitions, there were consistent losses to
acquiring company shareholders.
• Andrade, Mitchell and Stafford (2001)
– US event study, found large abnormal returns to target
company shareholders.
– No significant effect to bidder company shareholders.
– Overall shareholder wealth effect is positive and significant.
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19-29
Empirical Evidence on Takeovers:
Are Takeovers Poor Investments?
(cont.)
• Long-term abnormal returns
– Loughran and Vijh (1997) — US study finds differences
between announcement period (short-term) returns and
long-term returns to takeovers.
– 5-year abnormal returns differed depending on form
of payment.
– Share offers had returns of 24%, cash offers had returns of
+18.5%.
– Related to hostility of takeover.
– Brown and da Silva Rosa (1998) — Australian study finds
no long-term abnormal returns.
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19-30
Distinguishing between Good
and Bad Takeovers
• Roll’s hubris hypothesis
– Managers pay too much for target companies because
they overestimate their ability to run them.
• Managers may pursue their own objectives rather
than those of their shareholders:
– Often the result of free cash flow problems.
• Some managers may make unprofitable takeovers
simply because they are poor managers:
– Such managers are possibly seeking other fields in which
they hope to perform better.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-31
Distinguishing between Good
and Bad Takeovers (cont.)
• Mitchell and Lehn (1990)
– Results suggest the stock market is able to distinguish
between ‘good’ and ‘bad’ bidders.
– Results consistent with the argument that one role
of takeovers is to discipline managers who fail to
maximise profits, including those that make valuereducing takeovers.
• Morck, Shleifer and Vishny (1990)
– Found that acquiring companies do systematically pay
too much in takeovers in which the benefits for managers
are particularly large.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-32
The Net Effects of Takeovers
• Some researchers have preferred to use accounting
data to assess the effects of takeovers on company
performance by examining measures of profitability,
risk and growth.
• Recent Australian evidence on takeovers in various
industries finds little accounting evidence of improved
post-acquisition performance.
• Healy, Palepu and Ruback (1992):
– Used both accounting data and share price data and
focused on operating cash flows before interest and tax
to minimise the problems with accounting data.
– Their results provided further evidence that mergers do
result in improved performance.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-33
The Sources of Gains from
Takeovers (cont.)
• da Silva Rosa and Walter (2004) survey of
Australian evidence:
– Takeovers initiated by high performing companies that
are seeking to continue high performance.
– Target shareholders enjoy significant gains that dissipate
if takeover is unsuccessful with no follow-up bid.
– Shares in acquiring firm tend to under-perform following
acquisition. Related to high costs associated with
Australian regulatory environment.
– Long-run performance of combined entities suggest
anticipated benefits often fail to materialise.
– Qualify their results by stating that methodological
problems make it difficult to arrive at strong conclusions.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-34
Summary
• Takeovers are an important part of the market for
corporate control.
• Like any investment, a takeover should proceed
only if it has a positive NPV.
• Takeover activity in Australia can be erratic;
industry shocks, including deregulation, play an
important role.
• Three main types of takeover: horizontal, vertical
and conglomerate.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-35
Summary (cont.)
• Reasons for takeovers include:
– Assets can be used more efficiently under new
management.
– Synergistic gains.
– Diversification and EPS benefits dubious.
• Takeovers regulated by Corporations Act intend
that all parties are treated fairly and have enough
information to make a fully informed decision.
• Value-enhancing corporate restructures include
divestitures, spin-offs and buyouts.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-36
Summary (cont.)
• Evidence shows that target company shareholders
gain, but bidding company shareholders do not
gain as much, if at all.
• Takeovers paid for in shares tend to be less
successful for the acquiring company, seeming to
benefit managers interests, indicating problems
with agency costs.
• Recent Australian evidence shows that while
acquirers are well motivated, main gainers from
takeovers are target shareholders, while
anticipated benefits for acquirers fail to materialise.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
19-37