CHAPTER 29
MERGERS AND ACQUISITIONS
SLIDES
CHAPTER ORGANIZATION
29.1 The Basic Forms of Acquisitions
Merger or Consolidation
Acquisition of Stock
Acquisition of Assets
A Classification Scheme
A Note about Takeovers
29.2 Synergy
29.1 Key Concepts and Skills
29.2 Chapter Outline
29.3 The Basic Forms of Acquisitions
29.4 Merger versus Consolidation
29.5 Acquisitions
29.6 Varieties of Takeovers
29.7 Synergy
29.8 Synergy
29.9 Sources of Synergy
29.10 Calculating Value
29.11 Two Financial Side Effects of Acquisitions
29.12 A Cost to Stockholders from Reduction in Risk
29.13 The NPV of a Merger
29.14 Cash Acquisition
29.15 Stock Acquisition
29.16 Friendly vs. Hostile Takeovers
29.17 Defensive Tactics
29.18 More (Colorful) Terms
29.19 Have Mergers Added Value?
29.20 Have Mergers Added Value?
29.21 The Tax Forms of Acquisition
29.22 Accounting for Acquisitions
29.23 Going Private and Leveraged Buyouts
29.24 Divestitures
29.25 Quick Quiz
29.3 Sources of Synergy
Revenue Enhancement
Cost Reduction
Tax Gains
Reduced Capital Requirements
29.4 Two Financial Side Effects of Acquisitions
Earnings Growth
Diversification
29.5 A Cost to Stockholders from Reduction in Risk
The Base Case
Both Firms Have Debt
How Can Shareholders Reduce Their Losses from the Coinsurance Effect?
29.6 The NPV of a Merger
Cash
Common Stock
Cash versus Common Stock
29.7 Friendly versus Hostile Takeovers
29.8 Defensive Tactics
Deterring Takeovers before Being in Play
Deterring a Takeover after the Company Is in Play
29.9 Have Mergers Added Value?
Returns to Bidders
Target Companies
The Managers versus the Stockholders
29.10 The Tax Forms of Acquisitions
29.11 Accounting for Acquisitions
29.12 Going Private and Leveraged Buyouts
29.13 Divestitures
Sale
Spin-Off
Carve-Out
Tracking Stocks
ANNOTATED CHAPTER OUTLINE
Slide 29.0 Chapter 29 Title Slide
Slide 29.1 Key Concepts and Skills
Slide 29.2 Chapter Outline
29.1 The Basic Forms of Acquisitions
Slide 29.3 The Basic Forms of Acquisition
Bidder firm – the company making an offer to buy the stock or assets of
another firm
Target firm – the firm that is being sought
Consideration – cash or securities offered in an acquisition or merger
Lecture Tip: Overall, the massive wave of mergers and restructurings of
the 1980s resulted in increased competitiveness, lower costs, and greater
efficiency. A not-uncommon downside to the picture, however, is the job
loss and dislocation associated with the redeployment of corporate assets.
Unfortunately, popular press writers rarely grasp the true causes of such
events. One person who does is Peter Lynch, the successful former
manager of the Fidelity Magellan fund. Consider some of his statements.
“It’s amazing that the basic cause of downsizing is so rarely
acknowledged: these companies have more workers than they really need
– or can afford to pay.
CEOs aren’t callous Scrooges shouting ‘Bah, humbug!’ as they shove
people out the door; they are responding to a competitive situation that
demands that they become more productive.
If we must blame somebody for the layoffs, it ought to be you and me.
All of us are looking for the best deals in clothing, computers and
telephone service – and rewarding the high-quality, low-cost providers
with our business. I haven’t met one person who would agree to pay AT&T
twice the going rate for phone service if AT&T would promise to stop
laying people off. These companies are responding to the constant
pressure from consumers and shareholders.”
A. Merger or Consolidation
Merger – the complete absorption of one company by another (assets and
liabilities). The bidder remains, and the target ceases to exist.
Consolidation – a new firm is created. Joined firms cease their previous
existence.
Advantage – legally simple and relatively cheap
Disadvantage – must be approved by a majority vote of the shareholders of
both firms, usually requiring the cooperation of both sets of management
Slide 29.4 Merger versus Consolidation
Lecture Tip: Appearing relatively infrequently in previous decades, the
use of the hostile takeover bid to acquire control of a target firm exploded
in the 1980s. The term “corporate raider” (used previously to describe
someone who attempted to acquire board seats via a proxy contest)
entered the mainstream, and the stereotypical raider was cemented in the
public consciousness in the guise of the Gordon Gekko character from the
movie “Wall Street.”
Hostile takeover bids are often made via tender offer to current
shareholders, which obviates the need to obtain approval from the target
firm board. The rapid growth of hostile takeovers resulted in the creation
of an array of defensive mechanisms with which to fight them off.
Often, but not always, hostile bids are launched against firms that have
been performing poorly; the combination of a depressed share price and
dissatisfaction with management increases the bidder’s chance of success.
Of course, bids occur for other reasons; the series of attempts by Kirk
Kerkorian against Chrysler came following tremendous firm growth.
Kerkorian, however, wanted management to release some of the $7 billion
in cash reserves the firm had built up.
Lecture Tip: The merger wave of the 1990s is actually the fifth such wave
this century. The first occurred at the turn of the century and involved
approximately 1,500 mergers between 1895 and 1905. The second wave
coincided roughly with the decade of the 1920s and involved
approximately 2,000 transactions.
In the third wave during the late 1960s/early 1970s, annual activity
peaked with over 4,000 mergers in 1973. The late 1980s saw a high of
over 3,000 mergers in 1987. The 1990s was the largest wave, with nearly
8,000 mergers recorded in 1997.
B. Acquisition of Stock
Taking control by buying the voting stock of another firm with cash,
securities or both.
Slide 29.5 Acquisitions
Tender offer – offer by one firm or individual to buy shares in another firm
from any shareholder. Such deals are often contingent on the bidder
obtaining a minimum percentage of the shares; otherwise, no go.
Some factors involved in choosing between a tender offer and a merger:
1. No shareholder vote is required for a tender offer. Shareholders choose
to sell or not.
2. The tender offer bypasses the board and management of the target firm.
3. In unfriendly bids, a tender offer may be a way around unwilling
managers.
4. In a tender offer, if the bidder ends up with less than 80% of the target
firm’s stock, it must pay taxes on a portion of the dividends paid by the
target.
5. Complete absorption requires a merger. A tender offer is often the first
step toward a formal merger.
C. Acquisition of Assets
In an acquisition of assets, one firm buys most or all of another’s assets,
but liabilities are not involved as with a merger. Transferring titles can
make the process costly. The selling firm may remain in business.
D. A Classification Scheme
1. Horizontal acquisition – firms in the same industry
2. Vertical acquisition – firms at different steps of in the production
process
3. Conglomerate acquisition – firms in unrelated industries
Lecture Tip: It is useful to give names to the various types of mergers. For
example, McDonnell-Douglas/Boeing, MCI/British Telecommunications
PLC, and Chrysler/Daimler-Benz are all examples of horizontal mergers.
An example of a vertical merger would be Texaco (excess refining
capacity) and Getty Oil (significant oil reserves). U.S. Steel’s acquisition
of Marathon Oil would be a conglomerate acquisition.
Slide 29.6 Varieties of Takeovers
E. A Note about Takeovers
Lecture Tip: The popularity of proxy contests as a means of gaining
control has waxed and waned over the last five decades. In the 1950s, this
approach was a relatively popular means of removing target firm
management; as noted previously, those who initiated proxy contests were
even referred to in the popular press as “corporate raiders!” Empirical
evidence suggests, however, that proxy contests are time-consuming,
expensive for the dissident shareholder, and unlikely to result in complete
victory.
Tender offers came to the fore in the 1960s and 1970s. Some believe
that the use of the proxy battle waned because of its relatively high cost
and low probability of success. However, the ubiquity of takeover defenses
and regulatory constraints has contributed to the return of the importance
of the proxy battle as a means of gaining control.
Lecture Tip: An interesting example of a long, drawn-out proxy battle
appeared in The Wall Street Journal on October 8, 1996. Physician Steven
Scott founded Coastal Physicians Group, Inc., but was subsequently
ousted by its board of directors. Dr. Scott then filed suit and launched a
proxy fight. In return, the firm’s management counter-sued and blamed
him for the firm’s poor performance. Following several months of
wrangling, two candidates backed by Dr. Scott won board seats. The
struggle for control of Coastal is not unlike many proxy fights, in that they
are often associated with claims and counter-claims, lawsuits, and a great
deal of acrimony and expense.
29.2 Synergy
Slide 29.7 –
Slide 29.8 Synergy
The difference between the value of the combined firms and the sum of
the individual firms is the incremental gain:
V = VAB – (VA + VB).
Synergy – the value of the whole exceeds the sum of the parts
(V > 0)
The value of Firm B to Firm A = VB* = V + VB. VB* will be greater than
VB if the acquisition produces positive incremental cash flows, CF.
CF = EBIT + Depreciation – Taxes – Capital Requirements
CF = Revenue – Costs – Taxes – Capital Requirements
Lecture Tip: You may wish to provide a few examples of synergies that
may be realized from a merger. From an operational standpoint, the
merger may result in better utilization of excess capacity, such as the
Getty acquisition by Texaco. From a financial standpoint, the merger may
provide economies of scale in flotation costs or better access to the
financial markets. If the cash flows are less than perfectly correlated, the
probability of financial distress or bankruptcy may decrease, thereby
reducing the expected costs (assuming reduced variability does not have a
greater effect on the “option value” of equity).
29.3 Sources of Synergy
Slide 29.9 Sources of Synergy
A. Revenue Enhancement
1. Marketing gains – changes in advertising efforts, changes in the
distribution network, changes in the product mix
2. Strategic benefits (beachheads) – acquisitions that allow a firm to enter
a new industry that may become a platform for further expansion
3. Market power – reduction in competition or increase in market share
Lecture Tip: The text notes several reasons for M&A activity. The
following was sent via email to members of a mergers and acquisitions
listserv.
“Do you know a business experiencing a decline in sales, loss
of direction, no longer competitive, ineffective management, …
Or a business that’s being neglected by its corporate parent …
Or a [sic] owner
looking to retire that built a once successful business now
needing reinventing … or a company that needs strong
marketing, finance, and manufacturing disciplines … If you
know such a business … it will be worth your while to reply.”
B. Cost Reduction
1. Economy of scale – per unit costs decline with increasing output
2. Economies of vertical integration – coordinating closely related
activities or technology transfers
3. Complementary resources (economies of scope) – example: banks that
allow insurance or stock brokerage services to be sold on premises
4. Technology transfer
5. Elimination of inefficient management: If management is not doing its
job well, or others may be able to do the job better, acquisitions are one
way to replace management. The threat of takeover may be enough to
make managers act in the best interest of shareholders.
Lecture Tip: One of the fathers of modern takeover theory is Henry
Manne, who published Mergers and the Market for Corporate Control in
1965. In this seminal work, Manne proposes the (now commonly
accepted) notion that poorly run firms are natural takeover targets
because their market values will be depressed, permitting acquirers to
earn larger returns by running the firms successfully. This proposition has
been verified empirically in dozens of academic studies.
You might choose to use Jensen’s definition of the market for corporate
control: “the market in which competing managerial teams compete for
the right to manage corporate resources,” and use statistics provided in
his survey paper, as well as the follow-up by G. Jarrell, J. Brickley, and J.
Netter. (See “The Market for
Corporate Control: The Scientific Evidence,” Journal of Financial
Economics, vol. 11, April 1983, pp. 5 – 50, and “The Market for
Corporate Control: The Evidence Since 1980,” Journal of Economic
Perspectives, vol. 2, Winter 1988, pp. 49 – 68.)
C. Tax Gains
1. Net Operating Losses (NOL) – a firm with losses and not paying taxes
may be attractive to a firm with significant tax liabilities
-Carry-back and carry-forward provisions reduce incentive to merge
-IRS may disallow or restrict the use of NOL
2. Unused or increased debt capacity – adding debt can provide important
tax savings
3. Surplus funds – firms with significant free cash flow can:
-Pay dividends
-Repurchase shares
-Acquire shares or assets of another firm
Lecture Tip: The IRS requires that the merger must have justifiable
business purposes for the NOL carry-over to be allowed. And, if the
acquisition involves a cash payment to the target firm’s shareholders, the
acquisition is considered a taxable reorganization that results in a loss of
NOLs. NOL carry-overs are allowed in a tax-free reorganization that
involves an exchange of the acquiring firm’s common stock for the
acquired firm’s common stock. Additionally, if the target firm operates as
a separate subsidiary within the acquiring firm’s organization, the IRS
will allow the carry-over to shelter the subsidiary’s future earnings, but
not the acquiring firm’s future earnings.
D. Reduced Capital Requirements
1. A firm needing capacity acquires a firm with excess capacity rather than
build new
2. Possible advantages to raising capital given economies of scale in
issuing securities
3. May reduce the investment in working capital
Slide 29.10 Calculating Value
When calculating the gains from synergy, avoid the following mistakes:
1. Do not ignore market values. Use the current market value as a starting
point and ask, “What will change if the merger or acquisition takes place?”
2. Estimate only incremental cash flows. These are the basis of synergy.
3. Use the correct discount rate. Make sure to use a rate appropriate to the
risk of the cash flows.
4. Be aware of transaction costs. These can be substantial and should
include fees paid to investment bankers and lawyers, as well as disclosure
costs.
29.4 Two Financial Side Effects of Acquisitions
Slide 29.11 Two Financial Side Effects of Acquisitions
A. Earnings Growth
An acquisition may give the appearance of growth in EPS without actually
changing cash flows. This happens when the bidder’s stock price is higher
than the target’s, so that fewer shares are outstanding after the acquisition
than before.
Example: Pizza Shack wants to merge with Checkers Pizza. The merger
will not create any additional value, so assuming the market is not fooled,
the new firm, Stop ‘n Go Pizza, will be valued at the sum of the separate
market values of the firms.
Stop ‘n Go, is valued at $1,875,000 and has 125,000 shares outstanding
with a price of $15 per share. Pizza Shack stockholders receive 100,000
shares, and Checkers Pizza stockholders receive 25,000 shares of the
combined firm.
Before and after merger financial positions:
Before After
Pizza
Shack
Checkers
Pizza
Stop ‘n Go
Pizza
Total Earnings $150,000 $75,000 $225,000
Number of Shares 100,000 50,000 125,000
Earnings per Share $1.50 $1.50 $1.80
Price per Share $15.00 $7.50 $15.00
Price-to-Earnings
Ratio
10 5 8.33
Total Value $1,500,00
0
$375,00
0
$1,875,00
0
B. Diversification
A firm’s attempt at diversification does not create value because
stockholders could buy the stock of both firms, probably more cheaply.
Firms cannot reduce their systematic risk by merging.
Lecture Tip: In earlier chapters, we pointed out that conflicts of interest
may exist between stockholders and managers in publicly traded firms. As
noted above, diversification-based mergers do not create value for
shareholders (this was illustrated using option pricing theory in an earlier
chapter); however, these mergers may increase sales and reduce the total
variability of firm cash flows.
If managerial compensation and/or prestige is related to firm size, or
if less variable cash flows reduce the likelihood of managerial
replacement, then some mergers may be initiated for the wrong reasons –
they may be in the best interest of managers but not stockholders.
29.5 A Cost to Stockholders from Reduction in Risk