23-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
23-2
Chapter 23
Mergers, Acquisitions and Corporate
Control
Chapter Outline
The Market for Corporate Control
 Sensible Motives for Mergers
 Dubious Reasons for Mergers
 Evaluating Mergers
 Merger Tactics
 Leverage Buyouts
 Mergers and the Economy

copyright © 2003 McGraw Hill Ryerson Limited
23-3
The Market for Corporate Control
• Mergers


and Acquisitions (M&A)
When one company buys another, it is making
an investment.
Thus, the basic principles of capital investment
decisions apply:
 The
buyer should go ahead with the purchase if
it makes a net contribution to shareholders’
wealth.
But, why would one company
wish to acquire another?
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23-4
The Market for Corporate Control
• Mergers

and Acquisitions (M&A)
Although shareholders may own the company,
in most large corporations there is a separation
of ownership and management.
 Thus,
individual shareholders generally have
very little say in the operation of the firm.

Directors and managers can take actions
which are contrary to the shareholders’
interests.
 One
of the forces which keep them in line is that
others, recognizing that the value of the firm
could be enhanced, will try to replace the
Directors and/or management.
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23-5
The Market for Corporate Control
• Mergers

and Acquisitions (M&A)
There are four ways to change the
management of a firm:
A
proxy contest.
 The purchase of the firm by another firm
in a merger or acquisition.
 A leveraged buyout of the firm.
 A divestiture of the firm.
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23-6
The Market for Corporate Control
• Proxy



Battles
When a group of investors believes that the
Board and its management team should be
replaced, they can launch a proxy contest or
a proxy fight.
In a proxy contest, outsiders compete with
management for shareholders’ votes.
If the outsiders obtain enough proxies to elect
their own slate of Directors, once the new
Board is in place, it can replace the
management.
copyright © 2003 McGraw Hill Ryerson Limited
23-7
The Market for Corporate Control
• Proxy
Battles
Most proxy contests fail.
 Such fights can cost millions of dollars.

 Dissidents
who engage in such battles
must use their own money.
 Management can use the corporation’s
funds, and its lines of communication with
the shareholders, to defend itself.
copyright © 2003 McGraw Hill Ryerson Limited
23-8
The Market for Corporate Control
• Mergers


and Acquisitions
Proxy contests are rare – poorly performing
managers face a far greater risk from mergers
and acquisitions.
There are three ways for a firm to acquire
another firm:
1. Merge with it.
2. Purchase a majority of the shares.
3. Purchase some or all of the assets.

The first option is referred to as a merger; the
other two options are referred to as
acquisitions.
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23-9
The Market for Corporate Control
• Mergers

In a merger (sometimes called a statutory
acquisition), the acquiring company combines
all of the assets and liabilities of the target
company into one.
 The

and Acquisitions
target company ceases to exist.
In the second alternative, the acquiring
company attempts to buy the target firm’s
stock.
 The
target may continue to exist, but it is now
owned by the acquirer.
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23-10
The Market for Corporate Control
• Mergers


and Acquisitions
In the second option, payment for ownership of
the target company goes into the hands of the
target company’s shareholders.
In the third option, one firm acquires another by
buying the target firm’s assets.
 Payment
goes into the hands of the target firm.
 Sometimes the target sells only some of its
assets.
 If the target sells all its assets, then it continues
to exist as an independent entity, but only as an
empty shell.
copyright © 2003 McGraw Hill Ryerson Limited
23-11
The Market for Corporate Control
• Leveraged




Buyouts (LBO)
Sometimes a group of investors will takeover a
firm using an LBO.
An LBO involves the acquisition of a firm by a
private group using substantial borrowed
funds.
The LBO group then takes the firm private so
its shares no longer trade in the securities
markets.
If the investor group is led by the management
of the firm, then the takeover is called a
management buyout (MBO).
copyright © 2003 McGraw Hill Ryerson Limited
23-12
The Market for Corporate Control
• Divestitures
Instead of selling a business to another
firm, a company may spin-off the
business by separating it from the parent.
 This is done by distributing stock in the
newly independent company to the
shareholders of the parent company.

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23-13
Sensible Motives for Mergers
• Types

of Mergers
Mergers are often categorized as:
 Horizontal

When the merger takes place between firms in
the same business, e.g., Air Canada’s acquisition
of Canadian Airlines.
 Vertical

When the merger involves acquiring a supplier or
customer, e.g., Pepsi owns Burger King.
 Conglomerate

When the merger involves companies in unrelated
businesses, e.g., a manufacturer acquires a bank.
copyright © 2003 McGraw Hill Ryerson Limited
23-14
Sensible Motives for Mergers
• When


Mergers Make Sense
A merger makes sense only if it adds value.
Value may be added by better management, or
by synergies, and other changes, which make
the two firms worth more together than they
were apart:
FIRM A
FIRM B
>
FIRM A
+
FIRM B
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23-15
Sensible Motives for Mergers
• When

Mergers Make Sense
Sources of synergy:
 Increased
revenues for the combined
companies, perhaps because of increased
prices or a larger market.
 Economies of scale, i.e., the opportunity to
reduce per unit costs by spreading fixed costs
over a larger number of units.
 Economies of vertical integration, i.e.,
improvements in co-ordination and control of
production.
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23-16
Sensible Motives for Mergers
• When

Mergers Make Sense
Sources of synergy:
 Combining
complementary resources, i.e., one
of the firms provides the missing ingredient
necessary to the other’s success.
 Merging to reduce taxes, i.e., if it is possible to
reduce the total taxes of the combined
companies, say because one has tax shields it
is unable to use.
 Using surplus funds, i.e., if one of the firms has
a shortage of good investment opportunities,
and is unwilling to buy its own shares, it may
instead purchase someone else’s.
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23-17
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
Diversification
 Diversification
reduces risk, which is beneficial.
 However, diversification is easier and cheaper
for shareholders to accomplish than it is for
companies to do by combining their operations.
Shareholders just have to buy shares of company
A and company B to diversify their portfolio.
 Thus, they will not pay a premium for managers to
combine company A and company B merely for
the sake of diversification.

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23-18
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
The Bootstrap Game
 During
the 1960’s, some conglomerate
companies made acquisitions which
offered no evident economic gains.
 Yet, the conglomerates were able to
produce several years of rising earnings
per share (and, of course, rising share
prices).
 Let’s see how this could happen.
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23-19
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
The Bootstrap Game
 Table
23.2 on page 691 of your text shows
the financial situation for two firms:
World Enterprises (WE) is a rapid growth
firm, with a high stock price and P/E ratio.
WE has 100,000 shares outstanding and eps
of $2.00.
 Muck and Slurry (M&S) is slow growth firm,
with a low stock price and P/E ratio.
M&S also has 100,000 shares outstanding and
eps of $2.00.

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23-20
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
The Bootstrap Game
 What
would happen to eps if WE were to
merge with M&S?
 If you look at column 3 of Table 23.3, you
will see that:
The total market value of the two
companies is unchanged by the merger.
 The total earnings of the two companies
is unchanged by the merger.

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23-21
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
The Bootstrap Game
 Thus,
the acquisition of M&S by WE
provides no economic gains.
 But, if you look at column 3 of Table 23.2,
you will see that the eps of the combined
company has increased from $2.00 to
$2.67.
Can you see why the post-merger
eps grew by 33%?
copyright © 2003 McGraw Hill Ryerson Limited
23-22
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
The Bootstrap Game
 Before
the merger, WE’s shares were selling for
$40, while M&S’s shares were selling for $20.
 Thus, WE gave-up only 1 of its shares to
acquire 2 of M&S’s shares.
 If you you look at lines 4 and 5 of Table 23.2 you
will see that the number of shares increased by
only 50%, but earnings increased by 100%.
 Thus, eps must grow – not for economic
reasons, but as a function of the math!
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23-23
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
The Bootstrap Game
 If
you look at Line 7 of Table 23.2, you will
see that before the merger:
WE shareholders bought high growth and
$0.05 of immediate earnings for each $1
invested.
 M&S shareholders bought low growth, but
$0.10 of immediate earnings for each $1
they invested.

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23-24
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
The Bootstrap Game
 If
you look at Line 7 of Table 23.2, you will
see that after the merger:
WE shareholders get lower growth and
$0.067 of immediate earnings for each $1
invested.
 M&S shareholders get higher growth, and
$0.067 of immediate earnings for each $1
they invested.

 Thus,
neither side gains or loses, provided
that everyone understands the deal.
copyright © 2003 McGraw Hill Ryerson Limited
23-25
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
The Bootstrap Game
 However,
financial manipulators try to
cheat investors by making sure the the
market does not understand the deal.
 If investors mistake the 33% increase for
sustainable growth, then the P/E ratio will
jump.
 The result: the price of the merged
company will rise and the shareholders of
both companies get something for nothing.
copyright © 2003 McGraw Hill Ryerson Limited
23-26
Dubious Reasons for Mergers
• When

Mergers Don’t Make Sense
The Bootstrap Game
 Lesson:
Buying a firm with a lower P/E ratio can
increase eps.
 But the increase in eps should not result in
a higher share price.
 The short-term, immediate increase in
earnings should be offset by lower future
earnings growth.

copyright © 2003 McGraw Hill Ryerson Limited
23-27
Evaluating Mergers
• Key

Questions
If you are evaluating a merger, there are
two questions you should think about:
 Is
there an overall economic gain to the
merger?

In other words, are the two firms worth
more together than apart?
 Do
the terms of the merger make my
company and shareholders better off?

There is no sense in merging if the costs
are too high.
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23-28
Evaluating Mergers
• Key

Questions
Let’s look at a sample merger, which
could be financed either by cash or by
shares, to see if we can understand
these concepts.
 Look at Table 23.3 on page 692.
It shows the financial data for Cislunar and
Targetco.
 Cislunar is considering merging with
Targetco.

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23-29
Evaluating Mergers
• Key

Questions
Note the following in Table 23.3:
 The
earnings of Cislunar and Targetco are
$32 m and $4 m respectively.
Combining the companies increases their
earnings by $4 m due to increased revenues
and savings on operating costs.
 This is the gain from the merger.

 Cislunar’s
share price is $48.
 Targetco shares sell at 1/3 the price: $16
each.
 The market value of Targetco is $40 m.
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23-30
Evaluating Mergers
• Key


Questions
The total economic gain to this merger is $4m
of extra earnings per year.
 Assume the earnings are a perpetuity and the
cost of capital is 20%:
Total Economic Gain = $4 m/ 0.20
= $20 m
Thus, you can say, “Yes, there is an overall
economic gain.”, in answer to our first key
question.
 This additional value is the basic motivation for
the merger.
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23-31
Evaluating Mergers
• Key



Questions
Your answer to Question 2 will be determined
by the terms of the merger.
 What is the cost of the merger to Cislunar
and its shareholders?
Targetco’s shareholders will not accept less
than $16 per share for their holdings.
Assume that Cislunar offers them $19 per
share.
What is the cost to Cislunar
and its shareholders?
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23-32
Evaluating Mergers
• Key

Questions
At $19 a share, Targetco’s shareholders
capture $7.5 m of the economic gain:
(2.5 m shares x $19/share) - $40 m market value
= $47.5 m - $40 m = $7.5 m

If Targetco’s shareholders get $7.5 m of
the economic gain, then Cislunar’s must
get $12.5 m of it:
$20 m - $7.5 m = $12.5 m
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23-33
Evaluating Mergers
• Key
Questions
Thus, the post-merger value of Cislunar
should be $492.5 m.
 This may be derived as follows:

Cislunar market value before:
+ Targetco market value before:
+ PV gain to merger
- Cash paid to Targetco
shareholders
= Post merger market value:
$480 m
$40 m
$20 m
-$47.5 m
$492.5 m
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23-34
Evaluating Mergers
• Key

Questions
To summarize, this merger makes sense
for Cislunar because:
1. It adds $20 m to overall value, i.e., the two
firms are worth more together than apart.
2. The merger makes Cislunar’s shareholders
better off.

Taretco’s shareholders capture only $7.5 m
of the $20 m increase in value, leaving
$12.5 m for Cislunar’s shareholders.
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23-35
Evaluating Mergers
• Key
Questions
But, what happens if Cislunar wants to
conserve cash and instead, pays
Targetco’s shareholders with new
Cislunar shares?
 This is the same merger, with $20 m of
economic gain, but with different financing.

What is the answer to our
two questions in this case?
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23-36
Evaluating Mergers
• Key

Questions
If you look at the bottom of the second column
of Table 23.4 on page 693, you will see the
answer:
Cislunar is worth $540 m after the merger,
which is $47.5 m more than under the all cash
offer.
 Why?

Cislunar gets to keep $47.5 m in cash that it had
previously given to Targetco’s shareholders.
nd line down – cash is $57.5 m in this
 Look at the 2
scenario, versus $10 m in the previous one.

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23-37
Evaluating Mergers
• Key Questions
 However, there are now 833,333 new
Cislunar shares outstanding:
 Since Cislunar’s shares were trading at 3x
the price of Targetco’s, Cislunar had to issue
3 shares for each Targetco share.
2.5 m Targetco shares  3 = 833,333 shares
Under the all cash offer, Cislunar’s shares
are worth $49.25 post merger.
 Using a share exchange, Cislunar’s shares
are worth $49.85 post merger or $0.60
more.

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23-38
Evaluating Mergers
• Key Questions
 Why do Cislunar’s shareholders do better
from the share exchange?
 With the cash offer, Cislunar’s shareholders
gave-up $7.5 m of the economic gain to
Targetco’s shareholders.
 However, with the share offer, they give up:
833,333 shares x $49.85/share - $40 m
= $41.5 m - $40 m = $1.5 m

Thus, Cislunar’s shareholders capture more
of the economic gain with the share
exchange, than they did with the cash offer.
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23-39
Merger Tactics
• Unfriendly
Takeovers
Some mergers are friendly; however,
some are called “hostile”.
 In a hostile merger, the managers of the
target company fight the “unwelcome”
offer from the acquiring company.
 A number of tactics have developed in
the M&A business for such hostile
mergers.

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23-40
Merger Tactics
• Unfriendly

Takeovers
Shareholders’ rights plan or poison pill.
 Measures
taken by the target firm to avoid
acquisition by an unwelcome bidder.
 For example, giving existing shareholders the
right to buy additional shares at an attractive
price if a bidder acquires a significant holding.

White knight
 Friendly
potential acquirer sought by a target
company that is threatened by an unwelcome
bidder.
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23-41
Merger Tactics
• Unfriendly

Takeovers
Shark repellant
 Amendments
to a company charter that
make it more difficult for a successful
bidder to get control of the Board of
Directors.
For example, staggering the election of the
Directors so that 1/3 get elected each year.
 This means the bidder cannot obtain
majority control of the Board immediately
after acquiring a majority of the shares.

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23-42
Summary of Chapter 23

If a company’s managers are under-performing,
there are 4 ways to effect changes:
A
proxy battle.
 Acquisition of the firm by another firm.
 Acquisition of the firm by a private group of
investors in an LBO.
 Divestiture of the firm.

There are 3 ways for a firm to acquire another:
 It
can merge all the assets and liabilities of the
target into its own company.
 It can acquire the stock of the target.
 It can buy the assets of the target.
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23-43
Summary of Chapter 23



It makes sense for companies to merge when
there is an economic gain from the transaction.
This may occur because inefficient management
is replaced or because there are synergies
involved in the acquisition.
Some sources of synergy are:
 Increased
revenues.
 Economies of scale.
 Economies of vertical integration.
 Complementary resources
 Reduced Taxes.
 Redeployment of surplus funds.
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23-44
Summary of Chapter 23



We do not know how frequently these benefits
occur, but they do make economic sense as
reasons for a merger.
Sometimes mergers are undertaken to diversify
risks or to artificially inflate growth of eps.
These motives are of dubious value in justifying
a merger.
copyright © 2003 McGraw Hill Ryerson Limited