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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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Education.
20-2
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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20-4
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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Education.
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