Chapter 9
Fundamentals of
Corporate Finance
Mergers,
Acquisitions, and
Corporate Control
Slides by
Matthew Will
McGraw Hill/Irwin
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Topics Covered
The Market for Corporate Control
Sensible Motives for Mergers
Dubious Reasons for Mergers
Evaluating Mergers
Merger Tactics
Leveraged Buy-Outs
The Benefits and Costs of Mergers
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The Merger Market
Methods to Change Management
Proxy
battle for control of the board of directors
Firm purchased by another firm
Leveraged buyout by a group of investors
Divestiture of all or part of the firm’s business
units
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Recent Mergers
Acquiring Company
American Online
Chevron
JDS Uniphase
Deutsche Telecom
BP Amoco (UK)
Echostar Communications
Hewlett-Packard
American Intl. Group
Phillips Petroleum
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Selling Company
Time Warner
Texaco
SDL, Inc.
VoiceStream Wireless
Atlantic Richfield
Hughes Electronics
Compaq Computer
American General Corp.
Conoco
Payment
($ billions)
106.0
42.9
41.1
29.4
27.2
25.8
25.0
24.6
24.2
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The Merger Market
Tools Used To Acquire Companies
Proxy Contest
Tender Offer
Acquisition
Merger
Leveraged
Buy-Out
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Management
Buy-Out
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Sensible Reasons for Mergers
Economies of Scale
A larger firm may be able to reduce its per unit cost by
using excess capacity or spreading fixed costs across more
units.
Reduces costs
$
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$
$
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Sensible Reasons for Mergers
Economies of Vertical Integration
Control over suppliers “may” reduce costs.
Over integration can cause the opposite effect.
Pre-integration
(less efficient)
Post-integration
(more efficient)
Company
S
S
S
S
S
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Company
S
S
S
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Sensible Reasons for Mergers
Combining Complementary Resources
Merging may results in each firm filling in the
“missing pieces” of their firm with pieces from the
other firm.
Firm A
Firm B
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Sensible Reasons for Mergers
Mergers as a Use for Surplus Funds
If your firm is in a mature industry with few, if
any, positive NPV projects available, acquisition
may be the best use of your funds.
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Dubious Reasons for Mergers
Diversification
Investors
should not pay a premium for
diversification since they can do it themselves.
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Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to low
number of shares)
After merger, acquiring firm has short term
EPS rise
Long term, acquirer will have slower than
normal EPS growth due to share dilution.
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Dubious Reasons for Mergers
The Bootstrap Game
World Enterprises
(before merger)
EPS
Price per share
P/E Ratio
Number of shares
Total earnings
Total market value
20
100,000
$200,000
$4,000,000
Current earnings
per dollar invested
in stock
$0.05
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$2.00
$40.00
World Enterprises
(after buying Muck
and Slurry)
Muck and Slurry
$2.00
$2.67
$20.00
$40.00
10
15
100,000
150,000
$200,000
$400,000
$2,000,000
$6,000,000
$0.10
$0.067
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Evaluating Mergers
Questions
Is
there an overall economic gain to the
merger?
Do the terms of the merger make the company
and its shareholders better off?
????
PV(AB) > PV(A) + PV(B)
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Evaluating Mergers
Economic Gain
Economic Gain = PV(increased earnings)
=
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New cash flows from synergies
discount rate
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Evaluating Mergers
Example - Given a 20% cost of funds, what is the
economic gain, if any, of the merger listed below?
Cislunar Foods Targetco Combined Company
Revenues
150
20
172
(+2)
Operating Costs
118
16
132
(-2)
Earnings
32
4
40
(+4)
4
Economic Gain =
= $20
.20
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Evaluating Mergers
Estimated net gain
Estimated net gain = DCF valuation of target including synergies
- cash required for acquisition
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Merger Tactics
White Knight - Friendly potential acquirer sought
by a target company threatened by an unwelcome
suitor.
Shark Repellent - Amendments to a company
charter made to forestall takeover attempts.
Poison Pill - Measure taken by a target firm to avoid
acquisition; for example, the right for existing
shareholders to buy additional shares at an
attractive price if a bidder acquires a large holding.
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Leveraged Buy-Outs
Unique Features of LBOs
Large portion of buy-out
financed by debt
Shares of the LBO no longer
trade on the open market
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Leveraged Buy-Outs
Potential Sources of Value in LBOs
Junk
bond market
Leverage and taxes
Other stakeholders
Leverage and incentives
Free cash flow
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Summary
A merger generates an economic gain if the two
firms are worth more together than apart. Suppose
the firms A and B merge to form a new entity, AB,
then the gain from the merger is:
 Gain  PVAB - (PVA  PVB )  PVAB
Gains from mergers may reflect economies of scale,
economies of vertical integration, improved
efficiency, fuller use of tax shields, the combination
of complementary resources or redeployment of
surplus funds.
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In other cases , there may be no advantage of
combining two businesses but the object of
the acquisition is to install a more efficient
management team. There are also dubious
reasons for mergers. There is no value added
by merging just to diversify risks, to reduce
borrowing costs or to pump up earnings per
share. In many cases, the object of merging is
to replace management or to force changes in
investment or financing policies.
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Many of the takeovers in the 1980s were
diet deals in which companies were forced
to sell assets, cut costs or reduce capital
expenditures. The changes added value
when the target company had ample free
cash flow but was over investing or not
trying hard enough to reduce costs or
dispose of underutilized assets.
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You should go ahead with the merger if the gain
exceeds the cost. Cost is the premium that the
buyer pays for the selling firm over its value as a
separate entity. It is easy to estimate when the
merger is financed by cash. In that case, Cost =
cash paid –PVB
When payment is in the form of shares, the cost
naturally depends on what those shares are worth
after the merger is complete. If the merger is a
success, B’s stockholders will share the merger
gains.
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The mechanics of buying a firm are much more
complex than those of buying a machine.
First, you have to make sure that the purchase
does not fall a foul on anti thrust laws.
 Second, you have a choice of procedures: You can
merge all the assets and liabilities of the seller into
those of your own company, you can buy the stock
of the seller rather than the company itself or you
can buy the individual assets of the seller.
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Third, you have to worry about the tax
status of the merger. In a tax free merger,
the tax position of the corporation and the
stockholders is not changed. In a taxable
merger, the buyer can depreciate the full
cost of the tangible assets acquired but tax
must be paid on any write up of the assets’
taxable value, and the stockholders in the
selling corporation are taxed on any capital
gains.
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Mergers are often negotiated between the
management and directors of the two
companies. Selling shareholders earn large
abnormal returns while the bidding firm’s
shareholders roughly break even. The
typical merger appears to generate positive
net benefits for investors but the
competition among bidders plus active
defense by target management pushes most
of the gains toward the selling shareholders.
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Web Resources
Click to access web sites
Internet connection required
www.cfonews.com
http://cnn.news.com
www.mergerstat.com
www.globalfindata.com
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