Chapter 25
•Mergers and Acquisitions
McGraw-Hill/Irwin
Copyright © 2006 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 a
paying for an acquisition
• Understand the various defensive tactics
that are available
25-1
Chapter Outline
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The Legal Forms of Acquisitions
Taxes and Acquisitions
Accounting for Acquisitions
Gains from Acquisition
Some Financial Side Effects of Acquisitions
The Cost of an Acquisition
Defensive Tactics
Some Evidence on Acquisitions: Does M&A
Pay?
• Divestitures and Restructurings
25-2
Merger versus 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
25-3
Acquisitions
• 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
• 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
• Horizontal – both firms are in the same industry
• Vertical – firms are in different stages of the production process
• Conglomerate – firms are unrelated
25-4
Takeovers
• Control of a firm transfers from one group
to another
• Possible forms
• Acquisition
• Merger or consolidation
• Acquisition of stock
• Acquisition of assets
• Proxy contest
• Going private
25-5
Taxes
• 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
25-6
Accounting for Acquisitions
• Pooling of interests accounting no longer allowed
• 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
25-7
Synergy
• The whole is worth more than the sum of
the parts
• Some mergers create synergies because
the firm can either cut costs or use the
combined assets more effectively
• This is generally a good reason for a
merger
• Examine whether the synergies create
enough benefit to justify the cost
25-8
Revenue Enhancement
• Marketing gains
• Advertising
• Distribution network
• Product mix
• Strategic benefits
• Market power
25-9
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
25-10
Taxes
• Take advantages of net operating losses
• Carry-backs and carry-forwards
• 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
25-11
Reducing 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 human capital as well)
25-12
General Rules
• 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
• Consider transaction costs – these can
add up quickly and become a substantial
cash outflow
25-13
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
• In this case, the P/E ratio should fall
because the combined market value
should not change
• There is no free lunch
25-14
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
25-15
Cash Acquisition
• The NPV of a cash acquisition is
• NPV = 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 is
also desirable
25-16
Stock Acquisition
• Value of combined firm
• VAB = VA + VB + V
• Cost of 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
25-17
Defensive Tactics
• Corporate charter
• Establishes conditions that allow for a
takeover
• Supermajority voting requirement
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Targeted repurchase aka greenmail
Standstill agreements
Poison pills (share rights plans)
Leveraged buyouts
25-18
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
25-19
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 earn a small excess return
in a tender offer, but none in a straight merger
• 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
25-20
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
25-21
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?
25-22
Chapter 25
•End of Chapter
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
