Chapter
Twenty-Five
Mergers and
Acquisitions
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.1
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 a paying
for an acquisition
• Understand the various defensive tactics that
are available
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.2
Chapter Outline
•
•
•
•
•
•
•
•
The Legal Forms of Acquisitions
Taxes and Acquisitions
Accounting for Acquisitions
Gains from Acquisition
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition
Defensive Tactics
Some Evidence on Acquisitions
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.3
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
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.4
Acquisitions
• A firm can be acquired by purchasing voting shares of the
firm’s 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 different stages of the production process
– Conglomerate – firms are unrelated
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.5
Takeovers
• Control of a firm transfers from one group to
another
• Possible forms
– Acquisition
• Merger or consolidation
• Acquisition of stock
• Acquisition of assets
– Proxy contest
– Going private
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.6
Taxes
• Tax-free acquisition
– Business purpose; not solely to avoid taxes
– Continuity of equity interest – stockholders of
target firm must be able to maintain an equity
interest in the combined firm
– Generally, stock for stock acquisition
• Taxable acquisition
– Firm purchased with cash
– Capital gains taxes – stockholders of target may
require a higher price to cover the taxes
– Assets are revalued – affects depreciation expense
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.7
Accounting for Acquisitions
• Pooling of interests accounting no longer
allowed
• Purchase Accounting
– Assets of acquired firm must be reported at fair
market value
– Goodwill is created – difference between purchase
price and estimated fair market value of net assets
– Goodwill no longer has to be amortized – assets
are essentially marked-to-market annually and
goodwill is adjusted and treated as an expense if
the market value of the assets has decreased
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.8
Synergy
• The whole is worth more than the sum of the
parts
• Some mergers create synergies because the
firm can either cut costs or use the combined
assets more effectively
• This is generally a good reason for a merger
• Examine whether the synergies create enough
benefit to justify the cost
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.9
Revenue Enhancement
• Marketing gains
– Advertising
– Distribution network
– Product mix
• Strategic benefits
• Market power
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.10
Cost Reductions
• Economies of scale
– Ability to produce larger quantities while reducing
the average per unit cost
– Most common in industries that have high fixed
costs
• Economies of vertical integration
– Coordinate operations more effectively
– Reduced search cost for suppliers or customers
• Complimentary resources
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.11
Taxes
• Take advantages of net operating losses
– Carry-backs and carry-forwards
– Merger may be prevented if the IRS believes the
sole purpose is to avoid taxes
• Unused debt capacity
• Surplus funds
– Pay dividends
– Repurchase shares
– Buy another firm
• Asset write-ups
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.12
Reducing Capital Needs
• A merger may reduce the required investment
in working capital and fixed assets relative to
the two firms operating separately
• Firms may be able to manage existing assets
more effectively under one umbrella
• Some assets may be sold if they are redundant
in the combined firm (this includes human
capital as well)
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.13
General Rules
• Do not rely on book values alone – the market
provides information about the true worth of
assets
• Estimate only incremental cash flows
• Use an appropriate discount rate
• Consider transaction costs – these can add up
quickly and become a substantial cash outflow
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.14
EPS Growth
• Mergers may create the appearance of growth
in earnings per share
• 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
• In this case, the P/E ratio should fall because
the combined market value should not change
• There is no free lunch
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.15
Diversification
• Diversification, in and of itself, is not a good
reason for a merger
• Stockholders can normally diversify their own
portfolio cheaper than a firm can diversify by
acquisition
• Stockholder wealth may actually decrease
after the merger because the reduction in risk
in effect transfers wealth from the
stockholders to the bondholders
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.16
Cash Acquisition
• The NPV of a cash acquisition is
– NPV = VB* – cash cost
• Value of the combined firm is
– VAB = VA + (VB* - cash cost)
• Often, the entire NPV goes to the target firm
• Remember that a zero-NPV investment is also
desirable
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.17
Stock Acquisition
• Value of combined firm
– VAB = VA + VB + V
• Cost of acquisition
– Depends on the number of shares given to the target
stockholders
– Depends on the price of the combined firm’s stock after the
merger
• Considerations when choosing between cash and
stock
– Sharing gains – target stockholders don’t participate in
stock price appreciation with a cash acquisition
– Taxes – cash acquisitions are generally taxable
– Control – cash acquisitions do not dilute control
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.18
Defensive Tactics
• Corporate charter
– Establishes conditions that allow for a takeover
– Supermajority voting requirement
•
•
•
•
•
Targeted repurchase aka greenmail
Standstill agreements
Exclusionary self-tenders
Poison pills (share rights plans)
Leveraged buyouts
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.19
More (Colorful) Terms
•
•
•
•
•
•
•
Golden parachute
Poison put
Crown jewel
White knight
Lockup
Shark repellent
Bear hug
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.20
Evidence on Acquisitions
• 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
• 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
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
25.21
Quick Quiz
• What are the different methods for achieving a
takeover?
• How do we account for acquisitions?
• What are some of the reasons cited for
mergers? Which may be in stockholders’ best
interest and which generally are not?
• What are some of the defensive tactics that
firms use to thwart takeovers?
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.