978-1259277160 Chapter 20 Lecture Note

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External Growth through Mergers

Author’s Overview

The discussion of mergers and acquisitions brings together a number of topics discussed earlier

in the text. The instructor is able to take a second look at earnings per share growth,

price-earnings ratios, stockholder wealth maximization, and portfolio considerations. These

topics are considered in the present existing merger environment. Most students enjoy hearing

about unfriendly takeovers, proxy battles, White Knights and various defensive strategies.

A central consideration in the chapter is the effect of differential P/E ratios on postmerger

earnings per share. Once this concept is understood, the student should be encouraged to

consider why P/E ratios may differ for the acquiring firm and the merger candidate. At least

one major variable affecting P/E ratios is the possibility of differential future growth rates.

Through numerical analysis, the student begins to see that the short-term impact on earnings

per share can be very different from the long-term effect. Of greater importance, the student is

forced to consider what the impact of these short and long-term effects will be on the

postmerger valuation. Another important consideration is the portfolio effect associated with

the merger.

The price movement pattern associated with mergers is also worthy of consideration. Not only

is the material of interest to students who relate well to investment-oriented subjects, but it is

also an important consideration to corporate financial management. The premium offered and

the associated price movement may determine management’s strategy with regard to accepting

or fighting a proposal. This is particularly relevant in the latest merger movement in which

unfriendly offers for undervalued assets are commonplace.

We introduce the chapter with examples of Warren Buffets acquisitions of H.J. Heinz Company,

Lubrizol and the Burlington Northern Railroad and also present some of Berkshire Hathaway’s

portfolio holdings. Additionally we present the U.S. Airways American Airlines merger, which

was really the “shark” (U.S. Airways) eating the “whale” (American Airlines). Not to ignore

biotech we also present Gilead’s purchase of Pharmasset and consolidation in the energy

industry. This leads us into Table 20-1 where we present the largest acquisitions ever.

Chapter Concepts

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LO1. Firms engage in mergers for financial motives and to increase operating efficiency. Tax

benefits and other factors must also be considered.

LO2. Companies may be acquired through cash purchases or by one company exchanging its

shares for another company’s shares.

LO3. The potential impact of the merger on earnings per share and stock value must be

carefully assessed.

LO4. The diversification benefits of a merger should be evaluated.

LO5. Some buyouts are of an unfriendly nature and are strongly opposed by the potential

candidate.

Annotated Outline and Strategy

PPT Largest Acquisitions Ever (Table 20-1)

PPT Announced U.S. Mergers and Acquisitions: 1985-2014 (Figure 20-1)

I. Motives for Business Combinations

A. Business combinations may be either mergers or consolidations.

1. Merger: A combination of two or more companies in which the resulting

firm maintains the identity of the acquiring company.

2. Consolidation: Two or more companies are combined to form an entirely

new entity.

B. Financial Motives: It is often cheaper to acquire market share than it is to

develop it.

1. Portfolio Effect

a. Risk reduction as a result of the portfolio effect

b. Lower required rate of return by investors.

c. Higher value of the firm.

2. Access to Financial Markets

a. Greater access to financial markets to raise debt and equity

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capital.

b. Attract more prestigious investment bankers to handle financing.

c. Strengthen cash position and/or improve debt/equity ratio.

3. Tax Inversions

a. U.S. companies buying foreign companies and changing their

domicile to that lower-tax country to lower their overall tax rate.

b. The U.S. unlike most other developed countries, taxes all earning

from U.S. headquartered companies at the U.S. tax rate of 35%.

c. Most other developed countries tax the income at the tax rate in

the country where the income was earned.

3. Obtain a tax loss carryforward to offset future income.

Finance In Action: Are Diversified Firms Winners or Losers?

This is an interesting presentation about the merits of buying a diversified company or creating

an equal portfolio. What does the stock market see in the benefits or penalties of

diversification?

C. Non-Financial Motives

1. Expand management and marketing capabilities.

2. Acquire new products.

3. Synergy: 2 + 2 = 5.

D. Motives of Selling Stockholders

1. Desire to receive acquiring firm’s stock which may have greater

acceptability in the market.

2. Provides opportunity to diversify their holdings.

3. Gain on sale of stock at an attractive price.

4. Avoid the bias against smaller businesses.

Perspective 20-1: Mergers provide an opportunity to re-examine valuation models, cost of

capital and capital budgeting techniques from previous chapters. Concepts of growth and value

are relevant as are future benefits derived from the acquired company.

II. Terms of Exchange

A. Cash purchases

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1. Capital budgeting decision: Net present value of purchasing a going

concern equals the present value of cash inflows including anticipated

synergistic benefits minus cash outlays including adjustment for tax

shield benefit from any tax loss carryforward.

2. Many firms were purchased for cash in the 1970s and 1980s at a price

below the replacement costs of their assets, but the rising stock market of

the 1990s made this difficult to duplicate. Even after the stock market

retreat in 2000-2001 and again in 2008-9, companies were still selling

well above replacement costs.

B. Stock-for-Stock Exchange

1. Emphasizes the impact of the merger on earnings per share.

2. If the P/E ratio of the acquiring firm is greater than the P/E ratio of the

acquired firm, there will be an immediate increase in earnings per share.

3. Stockholders of the acquired firm are usually more concerned with

market value exchanged than earnings, dividends, or book value

exchanged.

PPT Financial Data on Potential Merging Firms (Table 20-2)

4. In addition to the immediate impact on earnings per share, the acquiring

firm must be concerned with the long-run impact of the merger on market

value.

5. An acquired firm may have a low P/E ratio because its future rate of

growth is expected to be low. In the long run, the acquisition may reduce

the acquiring firm’s earnings per share and its market value.

6. The acquisition of a firm with a higher P/E ratio causes an immediate

reduction in earnings per share. In the long run, however, the higher

growth rate of the acquired firm may cause earnings per share and the

market value of the acquiring company to be greater than if the merger

did not take place.

7. Determinants of earnings per share impact of a merger

a. Exchange ratio

b. Relative growth rates

c. Relative size of the firms

PPT Post-Merger Earnings per Share (Table 20-3)

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PPT Risk-Reduction Portfolio Benefits (Figure 20-2)

Perspective 20-2: The portfolio effect pertaining to mergers reinforces concepts learned in

Chapter 13. Issues of earnings correlation and synergy can be discussed and, if possible, you

might present a current merger situation with potential benefits and drawbacks.

C. Portfolio Effect

1. If the risk assessment of the acquiring firm is decreased by a merger, its

market value will rise even if the earnings per share remain constant.

2. Two types of risk reduction may be accomplished by a merger.

a. Business risk reduction may result from acquiring a firm that is

influenced by an opposite set of factors in the business cycle.

b. Financial risk reduction may result from a lower use of debt in the

post-merger financial structure of the acquiring firm.

III Accounting Considerations in Mergers and Acquisitions

A. Prior to December 2000, a merger was treated as either a pooling of interests or a

purchase of assets on the books of the acquiring firm. After December 6, 2000

pooling of interests was no longer allowed.

B. Criteria for pooling of interests treatment before December, 2000.

1. The acquiring firm issues only common stock, with rights identical to its

old outstanding voting stock in exchange for substantially all the voting

stock of the acquired company.

2. The acquired firm’s stockholders maintain an ownership position in the

surviving firm.

3. The merged firm does not intend to dispose of a significant portion of the

assets of the combined companies within two years.

4. The combination is effected in a single transaction.

C. Purchase of assets

1. Necessary when the tender offer is in cash, bonds, preferred stock, or

common stock with restricted rights.

2. Any excess of purchase price over book value is recorded as goodwill

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and written off over a maximum period of 40 years (with some

exceptions).

3. Before the accounting change goodwill had to be written off over a

maximum of 40 years. This caused a negative effect on postmerger

earnings. Under the new rules, goodwill does not have to be written off

unless there is a verifiable decrease in the value of the acquired firm.

IV. Negotiated versus Tender Offers

PPT Announced Mergers & Acquisitions: Hostile M&A 1985-2014

(Figure 20-3)

A. Friendly versus unfriendly mergers

1. Most mergers are friendly and the terms are negotiated by the officers

and directors of the involved companies.

2. Goodwill. During the 1970s and 1980s, takeover tender offers have

occurred frequently and many proposed mergers have been opposed by

the management of candidate firms.

B. Unfriendly takeover attempts have resulted in additions to the Wall Street

vocabulary

1. Saturday Night Special – a surprise offer made right before the market

closes for the weekend.

2. White Knight – a third firm that management of the target firm calls upon

to help avoid the initial, unwanted tender offer.

3. Leveraged takeover – the acquiring firm negotiates a loan based on the

target company’s assets (particularly a target company with large cash

balances).

C. Actions by target companies to avoid unwanted takeovers.

1. White Knight arrangements.

2. Moving corporate offices to states with protective provisions against

takeovers.

3. Buying up company’s own stock to reduce amount available for takeover.

4. Encouraging employees to buy stock under corporate pension plan.

5. Increasing dividends to keep stockholders happy.

6. Staggering election of members of the board of directors.

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7. Buying other firms to increase size.

8. Avoiding large cash balances, which encourage leveraged takeover

attempts.

Finance in Action: Why CEOs Like the Merger Game

This box discusses an interesting byproduct of corporate mergers: Although each company has

an executive team prior to a merger, only one CEO remains after most mergers. In order to

induce the departing CEO to go through with the merger, a large “golden parachute” may be

provided. This box may be worth discussing in the context of agency theory first presented in

Chapter 1.

V. Premium Offers and Stock Price Movements: The acquiring firm typically pays a

merger premium of between 0-60 percent over the pre-merger market price of the firm

being acquired.

Perspective 20-3: Table 20-4 demonstrates what happens to the price of the acquisition target

when the merger fails. This is a good example showing the premium between the

preannouncement price and the day after announcement and the subsequent collapse of the

stock price to below the preannouncement price. There is risk in speculating on mergers.

VI. Two -Step Buyout

A. The acquiring firm attempts to gain control by offering a very high cash price for

51 percent of the outstanding shares of the target firm. Simultaneously, a second

lower price is announced that will be paid, either in cash, stock, or bonds at a

subsequent point in time.

B. One problem with merger premiums is they usually disappear if the merger is

called off.

C. The procedure provides a strong incentive for stockholders of the target firm to

quickly react to the offer. Also, the two step buyout enables the acquiring firm

to pay a lower total price than if a single offer is made.

D. The SEC is keeping a close watch on the two-step buyout because of fears that

the less sophisticated stockholders may be at a disadvantage when competing

against arbitragers and institutional investors.

E. The discussion of the 3M acquisition of Ceradyne shows how a company can

technically avoid a two-step buyout and create the same price for all tendering

stockholders.

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Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 31, Acme Alarm Systems (Merger Terms and Stock Price)

Case 34, National Brands versus A-1 Holdings (Merger Analysis)

Case 35, KFC and the Colonel (Overall Business Considerations)

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