30-0
Chapter Thirty
Finance
Mergers andCorporate
Acquisitions
Ross  Westerfield  Jaffe
30
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-1
Chapter Outline
30.1 The Basic Forms of Acquisitions
30.2 The Tax Forms of Acquisitions
30.3 Accounting for Acquisitions
30.4 Determining the Synergy from an Acquisition
30.5 Source of Synergy from Acquisitions
30.6 Calculating the Value of the Firm after an Acquisition
30.7 A Cost to Stockholders from Reduction in Risk
30.8 Two "Bad" Reasons for Mergers
30.9 The NPV of a Merger
30.10 Defensive Tactics
30.11 Some Evidence on Acquisitions
30.12 Summary and Conclusions
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-2
30.1 The Basic Forms of Acquisitions
• There are three basic legal procedures that one firm
can use to acquire another firm:
– Merger
– Acquisition of Stock
– Acquisition of Assets
• Although these forms are different from a legal
standpoint, the financial press frequently does not
distinguish among them.
• In our discussions, we use the term merger
regardless of the actual form of the acquisition.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-3
Merger or Consolidation
• A merger refers to the absorption of one firm by another. The
acquiring firm retains its name and identity, and acquires all
the assets and liabilities of the acquired firm. After the
merger, the acquired firm ceases to exist as a separate entity.
• A consolidation is the same as a merger except that an
entirely new firm is created. In a consolidation, both the
acquiring firm and the acquired firm terminate their previous
legal existence.
• An advantage of using a merger to acquire a firm is that it is
legally straightforward and does not cost as much as other
forms of acquisition.
• A disadvantage is that a merger must be approved by a vote
of the shareholders of each firm.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-4
Acquisition of Stock
• A firm can acquire another firm by purchasing
target firm’s voting stock in exchange for cash,
shares of stock, or other securities.
• A tender offer is a public offer to buy shares made
by one firm directly to the shareholders of another
firm.
– If the shareholders choose to accept the offer, they tender
their shares by exchanging them for cash or securities.
– 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.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-5
Acquisition of Assets
• One firm can acquire another by buying all of its
assets.
• A formal vote of the shareholders of the selling firm
is required.
• Advantage of this approach: it avoids the potential
problem of having minority shareholders that may
occur in an acquisition of stock.
• Disadvantage of this approach: it involves a costly
legal process of transferring title.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-6
A Classification Scheme
• Financial analysts typically classify acquisitions
into three types:
– Horizontal acquisition: when the acquirer and the target
are in the same industry.
– Vertical acquisition: when the acquirer and the target are
at different stages of the production process; example: an
airline company acquiring a travel agency.
– Conglomerate acquisition: the acquirer and the target are
not related to each other.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-7
A Note on Takeovers
• Takeover is a general and imprecise term referring
to the transfer of control of a firm from one group
of shareholders to another.
• Takeover can occur by acquisition, proxy contests,
and going-private transactions.
• In a proxy contest, a group of shareholders attempts
to gain controlling seats on the board of directors by
voting in new directors.
• A proxy authorizes the proxy holder to vote on all
matters in a shareholders’ meeting.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-8
Varieties of Takeovers
Merger
Takeovers
Acquisition
Acquisition of Stock
Proxy Contest
Acquisition of Assets
Going Private
(LBO)
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-9
30.2 The Tax Forms of Acquisitions
• In a taxable acquisition, the shareholders of the
target firm are considered to have sold their shares,
and they will have capital gain/losses that will be
taxed.
• In a tax-free acquisition, since the acquisition is
considered an exchange instead of a sale, no capital
gain or loss occurs.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-10
30.3 Accounting for Acquisitions
• The Purchase Method
– The source of much “goodwill”
• Pooling of Interests
• 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.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-11
30.4 Determining the Synergy from an
Acquisition
• 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.
– 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.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-12
30.5 Source of Synergy from Acquisitions
• Revenue Enhancement
• Cost Reduction
– Including replacing ineffective managers.
• Tax Gains
– Net Operating Losses
– Unused Debt Capacity
• The Cost of Capital
– Economies of Scale in Underwriting.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-13
30.6 Calculating the Value of the Firm
after an Acquisition
• Avoiding Mistakes
–
–
–
–
Do not Ignore Market Values
Estimate only Incremental Cash Flows
Use the Correct Discount Rate
Don’t Forget Transactions Costs
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-14
30.7 A Cost to Stockholders from
Reduction in Risk
• The Base Case
– If two all-equity firms merge, there is no transfer of
synergies to bondholders, but if…
• One Firm has Debt
– The value of the levered shareholder’s call option falls.
• How Can Shareholders Reduce their Losses from
the Coinsurance Effect?
– Retire debt pre-merger.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-15
30.8 Two "Bad" Reasons for Mergers
• Earnings Growth
– Only 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.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-16
30.9 The NPV of a Merger
• 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.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-17
The NPV of a Merger: Cash
NPV of merger to acquirer =
Synergy – Premium
Synergy  VAB  (VA  VB )
Premium = Price paid for B - VB
NPV of merger to acquirer = Synergy - Premium
 VAB  (VA  VB )  [Price paid for B  VB ]
 VAB  VA  VB  Price paid for B  VB
 VAB  VA  Price paid for B
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-18
The NPV of a Merger: Common Stock
• The analysis gets muddied up because we need to
consider the post-merger value of those shares
we’re giving away.
Target firm payout    New firm value
New shares issued

Old shares  New shares issued
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-19
Cash versus Common Stock
• Overvaluation
– If the target firm shares are too pricey to buy with cash,
then go with stock.
• Taxes
– Cash acquisitions usually trigger taxes.
– Stock acquisitions are usually tax-free.
• Sharing Gains from the Merger
– With a cash transaction, the target firm shareholders are
not entitled to any downstream synergies.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-20
30.10 Defensive Tactics
• Target-firm managers frequently resist takeover
attempts.
• It can start with press releases and mailings to
shareholders that present management’s viewpoint
and escalate to legal action.
• Management resistance may represent the pursuit of
self interest at the expense of shareholders.
• Resistance may benefit shareholders in the end if it
results in a higher offer premium from the bidding
firm or another bidder.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-21
Divestitures
• The basic idea is to reduce the potential
diversification discount associated with commingled
operations and to increase corporate focus.
• Divestiture can take three forms:
– Sale of assets: usually for cash
– Spinoff: parent company distributes shares of a
subsidiary to shareholders. Shareholders wind up owning
shares in two firms. Sometimes this is done with a public
IPO.
– Issuance if tracking stock: a class of common stock
whose value is connected to the performance of a
particular segment of the parent company.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-22
The Control Block and The Corporate Charter
• If one individual or group owns 51-percent of a company’s
stock, this control block makes a hostile takeover virtually
impossible.
• Control blocks are typical in Canada, although they are the
exception in the United States.
• The corporate charter establishes the conditions that allow a
takeover.
• Target firms frequently amend corporate charters to make
acquisitions more difficult.
• Examples
– Staggering the terms of the board of directors.
– Requiring a supermajority shareholder approval of an acquisition
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-23
Repurchase Standstill Agreements
• In a targeted repurchase the firm buys back its own
stock from a potential acquirer, often at a premium.
• Critics of such payments label them greenmail.
• Standstill agreements are contracts where the
bidding firm agrees to limit its holdings of another
firm.
– These usually leads to cessation of takeover attempts.
– When the market decides that the target is out of play, the
stock price falls.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-24
Exclusionary Offers and Nonvoting Stock
• The opposite of a targeted repurchase.
• The target firm makes a tender offer for its own
stock while excluding targeted shareholders.
An example:
– In 1986, the Canadian Tire Dealers Association offered to
buy 49% of the company’s voting shares from the
founding Billes family.
– The offer was voided by the OSC, since it was viewed as
an illegal form of discrimination against one group of
shareholders.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-25
Going Private and LBOs
• If the existing management buys the firm from the
shareholders and takes it private.
• If it is financed with a lot of debt, it is a leveraged
buyout (LBO).
• The extra debt provides a tax deduction for the new
owners, while at the same time turning the previous
managers into owners.
• This reduces the agency costs of equity
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-26
Other Defensive Devices
• Golden parachutes are compensation to outgoing
target firm management.
• Crown jewels are the major assets of the target. If
the target firm management is desperate enough,
they will sell off the crown jewels.
• White Knight is a friendly bidder who promises to
maintain the jobs of existing management.
• Poison pills are measures of true desperation to
make the firm unattractive to bidders. They reduce
shareholder wealth.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-27
30.11 Some Evidence on Acquisitions: Stock Price
Changes in Successful U.S. Corporate Takeovers
Takeover
Technique
Tender offer
Merger
Proxy contest
McGraw-Hill Ryerson
Successful
Targets Bidder
30%
20%
8%
4%
0%
NA
© 2003 McGraw–Hill Ryerson Limited
30-28
Abnormal Returns in Successful Canadian
Mergers
Mergers 1964--83
Going private
Transactions 1977--89
- Minority buyouts
- Non-controlling bidder
McGraw-Hill Ryerson
Target
9%
Bidder
3%
25%
27%
24%
NA
NA
NA
© 2003 McGraw–Hill Ryerson Limited
30-29
Comparison of U.S. vs. Canadian
Mergers
• The evidence both in U.S. and Canada strongly
suggests that shareholders of successful target firms
achieve substantial gains from takeovers.
• Shareholders of bidding firms earn significantly less
from takeovers. The balance is more even for
Canadian mergers than for U.S. ones.
The reasons may be:
– There is less competition among bidders in Canada.
– The Canadian capital market is smaller.
– There are federal government agencies to review foreign
investments.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-30
30.12 Summary and Conclusions
•
The three legal forms of acquisition are
1. Merger and consolidation
2. Acquisition of stock
3. Acquisition of assets
•
•
M&A requires an understanding of complicated
tax and accounting rules.
The synergy from a merger is the value of the
combined firm less the value of the two firms as
separate entities.
Synergy  VAB  (VA  VB )
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited
30-31
30.12 Summary and Conclusions
•
The possible synergies of an acquisition come
from the following:
–
–
–
–
•
Revenue enhancement
Cost reduction
Lower taxes
Lower cost of capital
The reduction in risk may actually help existing
bondholders at the expense of shareholders.
McGraw-Hill Ryerson
© 2003 McGraw–Hill Ryerson Limited