Mergers & Acquisitions
FINC 446 Financial Decision Making
Dr. Olgun Fuat Sahin
1
Mergers and Acquisitions
• Vertical merger: forward or backward
integration
• Horizontal merger: expansion in a particular
business line
• Conglomerate merger: combination of
companies from unrelated business lines
2
Value Related Reasons for M&A
•
•
•
•
Synergism
Taxes
Information Asymmetry
Agency Costs
3
Synergism
• Synergism: Whole is worth more than sum of its parts
(M&A math is 2 + 2 = 5)
– Economies of scale – lower costs by combining operations
• Using excess capacity
• Spreading fixed costs over larger volume
– Economies of scope – can carry out more activities
profitably
• Producing similar products
• Backward integration – buying a supplier to reduce costs
• Forward integration – moving control one step closer to customers
4
Synergism (Continued)
– Economies of financing – larger companies can
raise money more economically
• The more money raised, the lower the issuance costs on
•
a per dollar raised
Higher liquidity for the securities reducing cost of
issuance to the firm
– Risk reduction – lower unsystematic risk will
reduce expected bankruptcy costs
– Market power – larger market share allows control
over price
5
Taxes
•
A merger can reduce the tax of a combined firm
because:
1.
2.
3.
4.
5.
The acquirer has large cash flows with limited opportunities –
returning cash to shareholders exposes them to taxes
Revaluing assets of the target can create depreciation expense
for tax purposes
Losses of a target that have been carried forward can be used
by the combined firm
Alternative Minimum Tax might encourage acquisitions by
reducing overall tax payment for firms if they are combined
Diversification through M&A can increase debt capacity
increasing tax shield
6
Information Asymmetry
• Acquiring company posses information that is
not available to the investors
• Buying another company implies that the
acquiring firm managers have found a
“bargain”
7
Agency Costs
• M&A allows inefficient managers to be
replaced
• Activities in the takeover market curb the
agency cost
8
Management Related Reasons for
Mergers
•
•
•
•
Reduction of Unsystematic Risk
Takeover Risk
Size Preference
Hubris Hypothesis
9
Reduction of Unsystematic Risk
• Diversification at the firm level will reduce the
unsystematic risk
– Previously this was good because lower
unsystematic risk reduces expected bankruptcy
costs
– Managers also benefit form lower unsystematic
risk because lower variability in earnings increases
job security and stabilizes compensation
10
Takeover Risk
• If a company is target for a proposed
acquisition then the target can make it difficult
by acquiring another – hard to swallow
• A defensive acquisition can create a regulatory
hurdle for the original suitor as well
11
Size Preference
• Managers’ self fulfilling prophecies – bigger is
better not necessarily profitable
• Larger firm can provide more compensation
for managers
12
Hubris Hypothesis
• Hubris hypothesis suggest that acquiring firm
managers rely too much on their abilities to
identify, undertake, and manage potential
targets
• Usual outcome of such acquisitions is a
disaster admitted by divestitures
13
M&A Process
•
•
•
•
•
Identify a Target
Valuation
Mode of Acquisition
Mode of Payment
Accounting of Acquisition
– Note: Regulators (Federal Trade Commission –
FTC) can block a deal or require substantial asset
sell off
14
M&A Process (Continued)
• Identify a Target:
– Based on a sound strategy that can increase
shareholders’ wealth
– Focus on “Value Related Reasons”
– Acquisitions are usually initiated by the acquiring
firm
– Sometimes a target can announce that it is for sale
15
M&A Process (Continued)
• Valuation:
• Net Cash Flow:
•
EBIT x (1 – tax rate)
+ depreciation and other non-cash expenses
– acquisition of new assets
+ increases in liabilities other than LTD
= Net cash flow
Equity Residual Cash Flow:
Net Income
– preferred dividends
+ depreciation and other non-cash expenses
– acquisition of new assets
+ increases (– decreases) in liabilities
+ increases (– decreases) in preferred stocks
= Equity residual cash flow
16
M&A Process (Continued)
• Valuation:
– Should not ignore the value of strategic options and
payment terms
– In general an acquisition creates wealth for the
acquirer if:
What Acquirer Gets
[Target Alone + Synergies + Other]
>=
What Acquirer Gives
[Cash Paid + Stock Paid + Debt Assumed]
17
M&A Process (Continued)
• Mode of Acquisition:
– Refers to whether a proposed acquisition is friendly or hostile to
target managers
• Friendly acquisitions are approved by board of directors
•
•
•
of each firm
Then shareholders vote on the proposal
If no negotiation possibility exists then an acquirer can
proceed with a tender offer to target shareholders –
making it hostile
Hostile takeover can be quite time consuming especially
when target managers fight against the tender offer
18
M&A Process (Continued)
• Mode of Payment:
– How an acquisition is paid for: cash, stock or
mixed
• If the stock is believed to be undervalued, then
stock should not be used for payment
• If the stock is overvalued then the stock
payment should/can be used
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Takeover Defense
• Golden parachute
– A contract designed to give executives substantial
compensation if they are dismissed following a
takeover
• Poison pills, flip-over rights allowing holders
to receive stock in the acquirer if the bidder
acquires 100% of the target
• Poison pills, flip-in rights allowing holders to
receive stock in the target
– It is effective against raiders who seek to acquire
controlling interest
20
Takeover Defense (Continued)
• Poison puts
– Bond issues that become due if unfriendly
takeover occurs
• Greenmail
– Managers of target buys shares purchased by
acquirer at a substantial premium
• White knight
– A third company acquiring the target with friendly
terms
21
Accounting Method
• There used to be two methods: Pooling of
Interest and Purchase method for acquisitions
• Pooling of Interest:
– It can be used if payment is made in the form of
acquirer’s stock
– Balance sheet and income statement of the
combined company are generated by adding up
items
22
Accounting Method (Continued)
• Purchase method:
– Balance sheet of the combined entity is constructed as follows:
If the price paid is same as the net asset value (book value –
total liabilities), balance sheet of the combined company is
generated by adding up items
– If the price paid is less than the net asset value, the assets are
written down
– If the price paid is more than the net asset value, the assets are
appraised. If the price is still more than appraised value of net
assets, the difference is an asset called goodwill
– The income statement reflect the depreciation expenses adjusted
for the revaluation
23
Accounting for Goodwill
• The Financial Accounting Standards Board (FASB)
•
issued two statements changing all that:
FASB Statement No. 141 Business Combinations
– Requires the purchase method of accounting be used for all
business combinations initiated after June 30, 2001
• FASB Statement No. 142 Goodwill and Other Intangible
Assets
– Changes the accounting for goodwill from an amortization
method to an impairment-only approach
– “Goodwill will be tested for impairment at least annually using
a two-step process that begins with an estimation of the fair
value of a reporting unit. The first step is a screen for potential
impairment, and the second step measures the amount of
impairment, if any.”
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Target and Acquirer Performance
around Announcement
• Dodd (1980), “Merger proposals, management discretion
and stockholder wealth,” Journal of Financial Economics,
Volume 8, Issue 2, June 1980, Pages 105-137
– 151 targets and 126 bidders over 1970-1977
Successful
Bidders
Targets
2-day AR *
-1.09%
13.41%
Sample Size
60
71
T-statistics
-3.0
23.8
2-day AR
-1.24%
12.73
66
80
-2.6
19.1
Unsuccessful Sample Size
T-statistics
* AR is Abnormal Return = Actual – Expected. Reported AR is average of firm ARs.
25
Target and Acquirer Performance
around Announcement (Continued)
• Bradley, Desai & Kim (1988), “Synergistic gains from
corporate acquisitions and their division between the
stockholders of target and acquiring firms”, Journal of
Financial Economics, Volume 21, Issue 1, May 1988,
Pages 3-40
– 3-day announcement abnormal return for 236 successful tender
offers over 1963-1984
Sample Size
Bidders
Targets
Total Sample
236
0.00%
21.6%
Single Bidders
163
0.65%
22.0%
Multiple Bidders
73
-1.45%
20.8%
26
Target and Acquirer Performance
around Announcement (Continued)
• Bradley, Desai & Kim (1983), “The gains to bidding
firms from merger,” Journal of Financial Economics,
Volume 11, Issues 1-4, April 1983, Pages 121-139
– 353 targets: 241 successful, 112 unsuccessful
– 94 unsuccessful bidders
– 1983-1980
Sample Size
Targets
112
35.6%
Subsequently Taken Over
86
39.1%
Not Subsequently Taken Over
26
23.9%
Unsuccessful Targets
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Acquirer Performance in the Long-Run
• Long Run Abnormal Return = Long-Run Actual
•
Return – Long-Run Expected Return
Long-Run Event Studies are very sensitive to “Joint
Hypothesis Problem”
– They test two hypotheses
• There is no abnormal performance after acquisitions – Null
• The method of risk adjustment (estimation of expected return) is
accurate. This is very important since we do not have an asset
pricing model that can explain security returns well
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Acquirer Performance in the Long-Run
(Continued)
Study
Sample
Expected Returns
AR Calculation
Major Results
Franks, Harris
and Titman
(1991)
399 acquisitions,
January 1975December 1984
(1) CRSP equal-weighted
market index
(2) CRSP value-weighted
market index
(3) Ten-factor model
(4) Eight portfolio
benchmark
Jensen’s α in eventtime and calendar-time
portfolios
Jensen’s α:
Average Abnormal Returns are (1) -0.2, (2) 0.29,
(3) -0.11, and (4) -0.11 per month over 36 months.
(1) and (2) are significant.
Calendar-time portfolios:
(2) 0.37 per month and significant
(4) does not detect any abnormal performance with
sub-samples as well
Agrawal Jaffe,
and Mandelker
(1992)
1,164 acquisitions,
January 1955December 1987
(1) Beta and size
(2) Returns Across Time and
Securities (RATS) with size
adjustment
CAAR, starting with
AD
CAAR for (1) is -10.26 for (+1, +60) and
significant. CAAR for model (2) is similar. No
abnormal performance during Franks, Harris and
Titman (1991) study period
Loderer and
Martin (1992)
1,298 acquisitions,
1955-1986
Similar to RATS
CAAR, starting with
effective date (ED)
Abnormal Returns are negative and significant over
3 years after acquisitions but insignificant over 5
years
Loughran and
Vijh (1997)
947 acquisitions,
1970-1989
Matching firm based on size
and book-to-market
Buy-and-Hold
Abnormal Return
(BHAR) starting with
ED
BHAR over five years is -6.5 and insignificant.
Cash BHAR is 18.5 and insignificant and Equity
BHAR is -25 and significant
Rau and
Vermaelen
(1998)
3,517 acquisitions,
January 1980December 1991
Size and book-to-market
matching portfolios
CAAR, starting with
CD
CAARs for mergers and tender offers are -4.04 and
8.85, respectively. Both figures are statistically
significant
Mitchell and
Stafford (2000)
2,193 acquisitions,
1958-1993
Size and book-to-market
matching portfolios
BHAR and CalendarTime Abnormal
Return (CTAR)
BHAR is zero for all acquisitions after adjusting for
cross-sectional dependence, CTAR is negative and
significant for equity financed acquisitions.
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