Mergers and Acquisitions
Dr. J.D. Han
King’s College,
University of Western Ontario
I. Two Latest Phenomena of
Corporate Financing
1) Traditionally, debts in corporate financing have
been more important than Equities.
2) The recent surge in Mergers and Acquisitions
(M & A) has raised D/E ratio through LBOs.
Sources of External Corporate Financing
in U. S. : 1970-1985
stocks
2%
bonds
32%
loans
66%
* In Canada, equity financing has a larger share. Why?
II. Why is debt financing more
important than equity financing?
Firm’s view point
-With tax (deductible interest expenses), cost of
debt is lower than cost of equity
-Equities are more vulnerable for hostile takeover
 Investor’s viewpoint
-Debts are safer than equities in terms of
“Principal-Agent Problem”.

1. Two major objectives of M & A:
Improved Management:
-A change in management and thus to an
enhanced EFFINCIENCY
-A just credible threat will wake up the stale
management.
 Synergy

2. Target for M & A: How do you know
whether a firm’s management is stale?
Free Cash Flow Theory
by Michael C. Jensen at HBS
“Agency Cost of Free Cash Flow, Corporate
Finance and Takeovers”, American Economic
Review (1986)
* * Free Cash Flows as a Litmus Test

Definition of FCF:
Free Cash Flows
= Cash Receipts - Cash Expenditures - Profitable
(Constructive) Investment Opportunities

Observation:
FCF are the likely object of the Management’s abuse
and the Principal-Agent Problem
*** Jensen’s FCF Theory in Reverse Gear
Dictum
“ The Larger the Free Cash Flow of a Firm, the
More Severe the Principal-Agent Problem, and
thus the Larger the Potential Benefits from M & A
and Corporate Restructuring”
 Prediction
We can also identify which firm is likely to be a
target of M & A.

3. M & A and LBO:
How does an Increased Indebtedness
enhance Corporate Efficiency?
1) Debt contracts have a better
monitoring and less moral hazards.
2) Reduced Equities increase
- ROE
- Management’s Financial Rewards
-> “Incentive-Compatible”
*Numerical Example of an Increased Indebtedness
enhancing Management’s Rewards
Restructuring is “Leveraged” Buyout (of Shareholders) by
Management

Before Restructuring
Debt-Equity Ratio = 0/1 = 0
Capital
Profits
Equity 1

After Restructuring
Debt –Equity Ratio = 9
Capital
Profits
Shareholders’ share
Debts
Shareholders’ share
$9,000
$9,000
$9,000
$ 900
Equity 2
Manager’s share
Equity 2
Manager’s share
$1,000
$1,000
$1,000
$9,100
Total
Total
$10,000
$10,000
*assume
interest rate =10%;
rate of returns on capital =100%
$10,000
$10,000
*Note: Manager’s profit share has
increased by 810%.
4. Two Structural Changes as
Prerequisites for a Surge of M & A


Lowering Legal Barriers
-Weakening of Anti-Trust Act(USA) Competition
Act(Canada)
Development of Financial Institutions,
Market & Debt Instruments
- Investment Banks, Securities Houses, Junk
Bonds, (Debt-Equity) Swap, etc.
5. Who are the Big Players?
Securities Firms
 Banks’ M & A Division of Investment Banking Department
 For instance
- Morgan Stanley
- Goldman Sachs
- Salomon Smith Barney
- Merrill Lynch
- Donald Trump; Drexel Burnham, Campeu Co., T. Boone
Pickens (Mesa Petrolium)

6. Pros and Cons of M& A
1) Pros: Advocate for M & A
M & A enhances Efficiency of Corporate
Management with synergy effect
(evidence) Share price of Target Firm goes up by
30-50% before and after M & A



Natural Part of Globalization Trend
Strategy for Survival from International
Competition
2) Criticism of M & A
(1) Zero Sum Game for the entire economy: gains for
shareholders come from someone’s loss
a) Government Loss of Tax Revenues in LBO
b) Wage Concessions after M & A
c) Bond holders’ loss: Increased leverage - Increased Default Risk
- Decreased Bond Price
d) Consumers’ loss: Increased monopoly power - Higher price
(2) Economic Frailty (= Bankruptcy risk + Increased
Interdependency)
(3) M & A could be costly: A High Transactions Cost
(3) A Costly M & A: “ Shark Repellants”
-Setting up costly barriers against M & A
 Green Mail
-bribe to a raider away

Scorch Earth or Crow Jewel
- make yourself unattractive

Poison Pills
- sell stock under market price in case of danger

Golden Parachute
- big severance package for leaving executives
IV. Canadian Context

M & A will continue to increase

M & A take on Globalization trends
1,400
$210
1,200
$180
1,000
$150
800
$120
600
$90
400
Announcements
200
$60
$30
0
0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Source: Crosbie & Company Inc.
Value in $ Billions
Announcements
Historical Canadian Mergers &
Acquisition Announcements
M & A at Canadian Cross-Border
YTD March 31, 1999
FY1998
FY1997
# of
Transactions
Value
$millions
# of
Transactions
Value
$millions
# of
Transactions
Value
$millions
Foreign Companies
56
2,997
309
54,176
303
25,362
Canadian Companies
from Foreigners
13
3,503
46
7,081
41
4,491
Total Canadian Buyers
69
6,500
355
61,257
344
29,853
Canadian Companies
50
20,159
152
18,977
142
11,638
Foreign Companies
from Canadians
13
990
60
14,068
52
15,709
Total Foreign Buyers
63
21,149
212
33,045
194
27,347
Canadians Acquiring:
Foreigners Acquiring:
M & A Resulting in Efficiency:
CanadianCases
YTD March 31, 1999
Average
Purchase Price ($mil)
Market Premium
FY1998
Median
$240.6
$29.4
FY1997
Average
Median
Average
Median
$217.1
$34.1
$126.6
$28.0
38%
33%
33%
28%
33%
26%
Revenue
4.1
1.9
3.3
2
3.3
2
Net Book Value
3.8
2.1
2.8
2.3
3.7
2.3
22.4
17.9
31.1
22.2
29.3
24.2
Price Mulitples:
Net Income
3. Case Studies
Case Study I) Excellent Execution - Onex Corporation

Classic Study Case of M & A
–

The Company’s objective is to build value for its
investors through the acquisition of underperforming
businesses( with a large amount of Free Cash Flow)
financed largely with debts borrowed from third party
lenders.
Performances.
- Acquired Celestica for C$750mm in October, 1996 which
now has a market value of C$4.6 billion.
- Onex announces a bid for Air Canada and Canadian
Airlines during a time when the industry is struggling.
Case Study - Excellent Execution - Onex Corporation
Stock Price Performance September 29, 1994 - September 30, 1999
30.00
Mar 25/99: Onex announces
Mar 11/99: Onex announces
that it will sell 23%
C$1.5bn Telecom Fund
May 11/99: Onex purchases
American Buildings
with Telefonica
of its stake in Sky
25.00
Chefs to LSG
Jan 29/99: Onex announces
LCS Industries acquisition
20.00
Aug 24/99: Onex
announces bid
15.00
Nov 13/96: ProSource
for Air Canada
completes IPO of US$48mm
and Canadian Airlines
Oct 1/96: Onex acquires
May 29/98: Onex sold
Celestica for C$750mm
10.00
Oct 1/98: Onex
announces
SoftBank acquisition
ProSource Inc. to
AmeriServe Food
Distribution for
C$123mm
5.00
09/29/1994 04/20/1995
11/07/1995 05/29/1996 12/16/1996 07/08/1997
Onex Corp Sub Vtg
01/27/1998 08/17/1998 03/09/1999 09/27/1999
Case Study 3 - High Yield Debt - Rogers Communications
Stock Price Performance September 29, 1994 - September 30, 1999
Sep 9/99: Rogers repurchases
35.00
C$1.3bn in debt
Nov 11/95: Rogers Cablesystems
July 12/99: Microsoft makes C$600mm
announces two new high yield
investment in Rogers; Aug 16/99: Completes
debt issues of US$150mm and US$125mm
sale of 33% interest of Rogers Cantel to
AT&T Corp and BT PLC for C$1.4bn
25.00
Jan 25/96: Issues
C$75mm high yield debt
July 17/97: Two new high yield
debt issues of US$330mm
15.00
and C$165mm announced
May 21/98: Rogers sells local
Jan 16/96: Issues US$100mm
telephone services to
high yield debt
Metronet for C$1bn
5.00
09/29/1994
04/20/1995
11/07/1995
05/29/1996
12/16/1996
07/08/1997
Rogers Communications Inc Cl
B
01/27/1998
08/17/1998
03/09/1999
09/27/1999