CHAPTER 26
MERGERS AND ACQUISITIONS
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KEY CONCEPTS AND SKILLS
• Discuss the different types of mergers and
acquisitions, why they should (or shouldn’t) take
place, and the terminology associated with them
• Describe how accountants construct the
combined balance sheet of the new company
• Define the gains from a merger or acquisition and
how to value the transaction
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CHAPTER OUTLINE
• The Legal Forms of Acquisitions
• Taxes and Acquisitions
• Accounting for Acquisitions
• Gains from Acquisitions
• Some Financial Side Effects of Acquisitions
• The Cost of an Acquisition
• Defensive Tactics
• Some Evidence on Acquisitions: Does M&A Pay?
• Divestitures and Restructurings
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THE LEGAL FORMS OF
ACQUISITIONS
• There are three basic legal procedures that one
firm can use to acquire another firm:
1. Merger or consolidation
2. Acquisition of stock
3. Acquisition of assets
• Although these forms are different from a legal
standpoint, the financial press frequently does not
distinguish between them.
 The term merger is often used regardless of the actual
form of the acquisition.
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MERGER TERMS
• The Bidder – the acquiring firm
• The Target Firm – the firm that is sought (and
perhaps acquired)
• The Consideration – cash or securities
offered to the target firm in the acquisition
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MERGER VS. 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.
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ACQUISITION OF STOCK
• A firm can be acquired by another firm or
individual(’s) purchasing voting shares of the firm’s
stock.
• Tender offer – public offer to buy shares made
directly by the bidder to target firm shareholders
 Those shareholders who choose to accept the offer
tender their shares by exchanging them for cash or
securities (or both), depending on the offer.
 A tender offer is frequently contingent on the bidder’s
obtaining some percentage of the total voting shares.
 If not enough shares are tendered, then the offer
might be withdrawn or reformulated.
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ACQUISITION OF STOCK (CTD.)
• Stock acquisition versus a merger
 No stockholder vote required with stock acquisition
 Can deal directly with stockholders in a stock acquisition,
even if management is unfriendly
 Resistance by the target firm’s management often makes
the cost of acquisition by stock higher than the cost of a
merger.
 Often, a significant minority of shareholders will hold out in
a tender offer, which will usually increase the cost and time
required for a merger.
 Complete absorption of one firm by another requires a
merger.
 Many acquisitions by stock are followed up with a formal
merger later.
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ACQUISITION OF ASSETS
• A firm can acquire another firm by buying most or all of its
assets.
• In this case, the target firm still exists unless the stockholders
choose to dissolve it.
• This type of acquisition requires a formal vote of the
shareholders of the selling firm.
• One advantage of an asset acquisition is that there is no
problem with minority shareholders holding out.
• One disadvantage of an acquisition of assets may involve
transferring titles to individual assets, which can be very costly.
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CLASSIFICATIONS OF
ACQUISITIONS
• Three types of acquisitions according to
financial analysts:
 Horizontal – both firms are in the same industry
 Vertical – firms are in different stages of the production
process
 Conglomerate – firms are unrelated
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TAKEOVERS
• Takeover - control of a firm transfers from one group to
another
• Possible forms of a takeover:
1. Acquisition
• Merger or consolidation
• Acquisition of stock
• Acquisition of assets
2. Proxy contest - an attempt to gain control of a firm by
soliciting a sufficient number of stockholder votes to
replace existing management
3. Going private - transactions in which all publicly owned
stock in a firm is replaced with complete equity
ownership by a private group
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GOING PRIVATE
• Leveraged buyouts (LBOs): going-private
transactions in which a large percentage of
the money used to buy the stock is
borrowed
 Often, incumbent management is involved
 Such transactions are also termed management buyouts
(MBOs) when existing management is heavily involved.
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ALTERNATIVES TO MERGER
• Strategic alliance: agreement between
firms to cooperate in pursuit of a joint goal
• Joint venture: typically an agreement
between firms to create a separate, coowned entity established to pursue a joint
goal
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TAXES AND ACQUISITIONS
• 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
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ACCOUNTING FOR ACQUISITIONS
• Since 2001, the Federal Accounting Standards
Board (FASB) requires that all acquisitions should be
treated under the purchase accounting method.
• 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
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GAINS FROM ACQUISITIONS
• There are a number of possible reasons why
a target firm will somehow be worth more in
our hands than it is worth now.
• To determine the gains from an acquisition,
we need to first identify the relevant
incremental cash flows, or, more generally,
the source of value.
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SYNERGY
• Synergy is the positive incremental net gain
associated with the combination of two
firms through a merger or acquisition.
• Synergy is generally a good reason for a
merger.
• Firms must examine whether the synergies
create enough benefit to justify the cost.
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POTENTIAL SOURCES OF SYNERGY
• From earlier chapters, the incremental cash flow,
ΔCF, can be broken down into four parts:
ΔCF = ΔEBIT + ΔDepreciation
+ ΔTax – ΔCapital requirements
ΔCF = ΔRevenue – ΔCost
– ΔTax – ΔCapital requirements
• The merger will make sense only if one or more of
these cash flow components are beneficially
affected by the merger.
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POTENTIAL REVENUE
ENHANCEMENT
• Marketing gains
 Improving advertising
 Improving the distribution network
 Improving an unbalanced product mix
• New strategic benefits
• Increasing market power
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POTENTIAL 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
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POTENTIALLY LOWER TAXES
• Take advantage of net operating losses.
 Carryforwards (carrybacks were eliminated by
the Tax Cuts and Jobs Act of 2017)
 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
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POTENTIAL REDUCTIONS IN
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 reducing
human capital as well).
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AVOIDING MISTAKES
• 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.
• Be aware of transaction costs – these can
add up quickly and become a substantial
cash outflow.
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INEFFICIENT MANAGEMENT
• Some firms could see a value increase with a
change in management.
• These are firms that are poorly run or otherwise do
not efficiently use their assets to create shareholder
value.
• Mergers are a means of replacing management in
such cases.
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FINANCIAL SIDE EFFECTS OF
ACQUISITIONS
• Financial side effects of a merger may occur
regardless of whether the merger makes economic
sense or not.
• Two such possible effects:
 EPS growth
 Diversification
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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.
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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.
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COST OF AN ACQUISITION
• Method 1: CASH ACQUISITION
 The cost of an acquisition when cash is used is
just the cash itself.
 The cash cost largely determines whether the
merger will be able to create value.
• Method 2: STOCK ACQUISITION
 In a stock merger, no cash actually changes
hands.
 Instead, the shareholders of the target firm come
in as new shareholders in the merged firm.
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CASH VS. STOCK ACQUISITION
• Cost of Stock 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
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DEFENSIVE TACTICS
• Target firm managers frequently resist takeover attempts.
 Resistance may make target firm shareholders better off if it elicits
a higher offer premium from the bidding firm or another firm.
• Some Defensive Tactics:
 Corporate charter
 Establishes conditions that allow for a takeover
 Supermajority voting requirement
 Targeted repurchase (a.k.a. greenmail)
 Standstill agreements
 Poison pills (share rights plans)
 Share rights plan
 Leveraged buyout (LBO) or management buyout (MBO)
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MORE (COLORFUL) TERMS – I
• Golden parachute:
 Some target firms provide compensation to top-level
managers if a takeover occurs.
• Poison put:
 Forces the firm to buy securities back at some set
price
• Crown jewel:
 Firms often sell or threaten to sell major assets—crown
jewels—when faced with a takeover threat.
 This is sometimes referred to as the scorched earth
strategy.
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MORE (COLORFUL) TERMS – II
• White knight:
 Firm facing an unfriendly merger offer might arrange to be
acquired by a different, friendly firm.
 The friendly firm is thereby rescued by a white knight.
 Alternatively, the firm may arrange for a friendly entity to
acquire a large block of stock.
 White knights can often increase the amount paid to the
target firm.
• Lockup:
 An option granted to a friendly suitor (a white knight,
perhaps) giving it the right to purchase stock or some of
the assets (the crown jewels, possibly) of a target firm at a
fixed price in the event of an unfriendly takeover
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MORE (COLORFUL) TERMS – III
• Shark repellent:
 Any tactic (a poison pill, for example) designed to discourage
unwanted merger offers
• Bear hug:
 An unfriendly takeover offer designed to be so attractive that the
target firm’s management has little choice but to accept it
• Fair price provision:
 A requirement that all selling shareholders receive the same price
from a bidder
 The provision prevents a “two-tier” offer.
 In such a deal, a bidder offers a premium price only for a
percentage of the shares large enough to gain control.
 It offers a lower price for the remaining shares.
 Such an offer can set off a stampede of shareholders.
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MORE (COLORFUL) TERMS – IV
• Dual class capitalization:
 Some firms, such as Google, have more than one
class of common stock, and that voting power is
typically concentrated in a class of stock not held by
the public.
 Such a capital structure means that an unfriendly
bidder will not succeed in gaining control.
• Countertender offer:
 Better known as the “Pac-Man” defense, the target
responds to an unfriendly overture by offering to buy
the bidder.
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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, on average, do not earn or lose
a large amount.
 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.
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DIVESTITURES AND
RESTRUCTURINGS
• Divestiture – company sells a piece of itself to
another company
• Equity carve-out – company creates a new
company out of a subsidiary and then sells a
minority interest to the public through an IPO
• Spin-off – company creates a new company out of
a subsidiary and distributes the shares of the new
company to the parent company’s stockholders
• Split-up – company is split into two or more
companies, and shares of all companies are
distributed to the original firm’s shareholders
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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?
• How can a firm restructure itself? How do these
methods differ in terms of ownership?
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ETHICS ISSUES
• In the case of takeover bids, insider trading is
argued to be particularly endemic because of the
large potential profits involved and because of the
relatively large number of people “in on the
secret.”
 What are the legal and ethical implications of trading
on such information?
 Does it depend on who knows the information?
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COMPREHENSIVE PROBLEM
• Two identical firms have yearly after-tax cash flows
of $20 million each, which are expected to
continue into perpetuity. If the firms merged, the
after-tax cash flow of the combined firm would be
$42 million. Assume a cost of capital of 12%.
 Does the merger generate synergy?
 What is change in overall firm value from the merger?
 What is the value of the target firm to the bidding
firm?
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END OF CHAPTER
CHAPTER 26
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