Chapter 19
Mergers and Acquisitions
McGraw-Hill/Irwin
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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 paying for
an acquisition
 Understand the various defensive tactics that
are available

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Chapter Outline
19.1 The Legal Forms of Acquisitions
19.2 Taxes and Acquisitions
19.3 Accounting for Acquisitions
19.4 Gains from Acquisition
19.5 Some Financial Side Effects of Acquisitions
19.6 The Cost of an Acquisition
19.7 Defensive Tactics
19.8 Some Evidence on Acquisitions: Does M&A Pay?
19.9 Divestitures and Restructurings
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
19.1 The Legal Forms of Acquisitions
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There are three basic legal procedures that
one firm can use to acquire another firm:
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Merger or Consolidation
Acquisition of Stock
Acquisition of Assets
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Merger versus Consolidation
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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
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Consolidation
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Entirely new firm is created from combination of
existing firms
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Acquisitions
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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
Stock acquisition
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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
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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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Varieties of Takeovers
Merger
Takeovers
Acquisition
Acquisition of Stock
Proxy Contest
Acquisition of Assets
Going Private
(LBO)
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19.2 Taxes and Acquisitions
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If it is a taxable acquisition, selling
shareholders need to figure their cost basis
and pay taxes on any capital gains.
If it is not a taxable event, shareholders are
deemed to have exchanged their old shares for
new ones of equivalent value.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
19.3 Accounting for Acquisitions
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The Purchase Method
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Pooling of Interests
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The source of much “goodwill”
Pooling of interest is generally used when the
acquiring firm issues voting stock in exchange for
at least 90 percent of the outstanding voting stock
of the acquired firm.
Purchase accounting is generally used under
other financing arrangements.
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19.4 Gains from Acquisition
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Most acquisitions fail to create value for the
acquirer.
The main reason why they do not lies in failures
to integrate two companies after a merger.
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Intellectual capital often walks out the door when
acquisitions aren't handled carefully.
Traditionally, acquisitions deliver value when they
allow for scale economies or market power, better
products and services in the market, or learning from
the new firms.
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Synergy
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Suppose firm A is contemplating acquiring
firm B.
The synergy from the acquisition is
Synergy = VAB – (VA + VB)
The synergy of an acquisition can be
determined from the standard discounted cash
flow model:
T
Synergy =
S
t=1
McGraw-Hill/Irwin
DCFt
(1 + r)t
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Sources of Synergy
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Revenue Enhancement
Cost Reduction
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Tax Gains
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Replacement of ineffective managers
Economies of scale or scope
Net operating losses
Unused debt capacity
Incremental new investment required in
working capital and fixed assets
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Calculating Value
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Avoiding Mistakes
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Do not ignore market values
Estimate only Incremental cash flows
Use the correct discount rate
Don’t forget transactions costs
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19.5 Some Financial Side Effects

Earnings Growth
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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 (i.e., an accounting
illusion).
Diversification

Shareholders who wish to diversify can accomplish
this at much lower cost with one phone call to their
broker than can management with a takeover.
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19.6 The Cost of an Acquisition


Typically, a firm would use NPV analysis
when making acquisitions.
The analysis is straightforward with a cash
offer, but gets complicated when the
consideration is stock.
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Cash Acquisition
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The NPV of a cash acquisition is:
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NPV = (VB + ΔV) – cash cost = 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 may
also be desirable.

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Stock Acquisition
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Value of combined firm
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Cost of acquisition
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VAB = VA + VB + DV
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
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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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19.7 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)
 Leveraged buyouts
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More (Colorful) Terms
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Golden parachute
Poison put
Crown jewel
White knight
Lockup
Shark repellent
Bear hug
Fair price provision
Dual class capitalization
Countertender offer
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
19.8 Evidence on Acquisitions

Shareholders of target companies tend to earn excess
returns in a merger:
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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.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Evidence on Acquisitions

Shareholders of bidding firms earn a small excess
return in a tender offer, but none in a straight merger:
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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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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
19.9 Divestitures and Restructurings
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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
McGraw-Hill/Irwin
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Quick Quiz
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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 of these 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?
McGraw-Hill/Irwin
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.