978-1259709685 Chapter 29 Lecture Note Part 2

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Slide 29.12 A Cost to Stockholders from Reduction in Risk

The coinsurance effect in a merger or acquisition occurs because

even if one of the pre-merger firm fails, bondholders will be still

be paid by the surviving firm. The coinsurance effect can reduce

the costs of financial distress if the cash flows between two firms

are not perfectly correlated. While this can increase total

stakeholders’ value, there may also be a transfer of value from the

stockholders to the bondholders through the coinsurance effect.

In the section on options, we showed that stocks can be valued as a

call option on the firm’s debt. In this view, bondholders own the

firm but sell shareholders an option to buy the firm at an exercise

price equal to the face value of debt. Recall that one of the inputs

to the OPM is the variability of the underlying asset. When the

variability of the underlying asset decreases, so does the value of

the call option.

Stapleton [1982] has shown that this is exactly what occurs when

two firms merge. Because of the coinsurance effect, the value of

equity (a call option) falls and there is a transfer of wealth from

stockholders to bondholders. The coinsurance effect, however, can

also result in greater debt capacity. This in turn means greater

interest tax shields and lower taxes.

A. The Base Case

If two all-equity firms merge, there is no transfer to bondholders,

since there are no bondholders.

B. Both Firms Have Debt

The coinsurance effect transfers value from stockholders to

bondholders.

C. How Can Shareholders Reduce Their Losses from the Coinsurance

Effect?

Retiring debt pre-merger can reduce the transfer of wealth.

Alternatively, the firm could increase debt usage after the merger.

29.2 The NPV of a Merger

Slide 29.13 The NPV of a Merger

The NPV of a merger = VB* – Cost to Firm A of the acquisition

Merger premium – amount paid above the stand-alone value

Reconsider Pizza Shack’s merger with Checkers Pizza. Suppose Pizza

Shack acquires Checkers in a buyout. Pizza Shack has estimated

the incremental value of the acquisition, V, to be $75,000. The

value of Checkers to Pizza Shack is VC* = V + VC = $75,000 +

$375,000 = $450,000. Checkers shareholders are willing to sell for

$400,000. Thus, the merger premium is $25,000 (the $400,000

payment less the current value of $375,000).

A. Cash

Suppose Pizza Shack pays Checkers’ stockholders $400,000 in cash.

Then, NPV = $450,000 – $400,000 = $50,000.

The value of the combined firm = $1,500,000 + $50,000 = $1,550,000

With 100,000 shares outstanding, the price per share becomes $15.50

Slide 29.14 Cash Acquisition

B. Common Stock

Suppose instead of cash, Pizza Shack gives Checkers stockholders

Pizza Shack stock valued at $15 per share. Checkers stockholders

will get 400,000 / 15 = 26,667 shares (rounded). The new firm will

have 126,667 shares outstanding and a value of $1,500,000 +

$375,000 + $75,000 = $1,950,000 for a per share price of $15.39.

The total consideration is 26,667(15.39) = $410,405.13. The extra

$10,405.13 comes from allowing Checkers stockholders

proportional participation in the $50,000 NPV.

Slide 29.15 Stock Acquisition

C. Cash versus Common Stock

1. Sharing gains – When cash is used, the target’s stockholders cannot

gain beyond the purchase price. Of course, they cannot fall below

either.

2. Taxes – Cash transactions are generally taxable; exchanging stock is

generally tax-free.

3. Control – Using stock may have implications for control of the

merged firm.

Lecture Tip: Emphasize that the logic used in determining the NPV of

an acquisition is the same as that used to find the NPV of any

other project. The acquisition is desirable if the present value of

the incremental cash flows exceeds the cost of acquiring them.

However, some financial theorists argue that many acquisitions

contain a “winner’s curse.” The argument is that the winner of an

acquisition contest is the firm that most overestimates the true

value of the target. As such, this bid is most likely to be excessive.

For a more detailed discussion of the “winner’s curse,” see Nik

Varaiya and Kenneth Ferris, “Overpaying in Corporate

Takeovers: The Winner’s Curse,” Financial Analysts Journal,

1987, vol. 43. no. 3. Richard Roll, in “The Hubris Hypothesis of

Corporate Takeovers,” Journal of Business, 1986, vol. 59, no. 2,

attributed the rationale for this behavior to hubris; i.e., the

excessive arrogance or greed of management.

29.3 Friendly versus Hostile Takeovers

Slide 29.16 Friendly vs. Hostile Takeovers

In a friendly merger, both companies’ management are receptive.

In a hostile merger, the acquiring firm attempts to gain control of

the target without their approval.

1. Tender offer – attempt to purchase enough shares to gain

control

2. Proxy fight – attempt to gather enough votes to force the

merger

29.4 Defensive Tactics

Slide 29.17 Defensive Tactics

Slide 29.18 More (Colorful) Terms

A. Deterring Takeovers before Being in Play

The Corporate Charter

-Usually, 67% of stockholders must approve a merger. A stronger

supermajority amendment requires 80% or more to approve a

merger.

-Staggered terms (classified) for board members

Poison Pills and Share Rights Plans

-In a share rights plan, the firm distributes rights to purchase stock

at a fixed price to existing shareholders. These cannot be detached

or exercised until “triggered,” but they can be bought back by the

firm. They are usually triggered when a tender offer is made.

Flip-over provision – the “poison” in the pill. Effectively, the target firm’s

shareholders get to buy stock in the merged firm at half price.

Golden parachutes – compensation to top management in the event

of a takeover

B. Deterring the Takeover after the Company Is in Play

Repurchase and Standstill Agreements

-A standstill agreement involves getting the bidder to agree to back

off, usually by buying the bidder’s stock back at a substantial

premium (targeted repurchase); also called greenmail.

Example: Ashland Oil buys off the Belzbergs of Canada in a targeted

repurchase. Ashland also had an established employee stock

ownership with 27% of outstanding shares and had earlier

adopted a supermajority provision.

White knights – target of hostile bid hopes to find a friendly firm

(white knight) to buy a large block of stock (often on favorable

terms) to halt takeover

Asset restructuring – sell off (or purchase) assets

Other Devices and Jargon of Corporate Takeovers

Poison puts – forces the firm to buy stock back at a set price

Crown jewels – a “scorched earth” strategy of threatening to sell major

assets

Lockups – option granted to friendly firm giving it the right to buy

stock or major assets at a fixed price in the event of a hostile

takeover

Shark repellent – any tactic designed to discourage unwanted

takeovers

Fair price provision – all selling shareholders must receive the same

price from the bidder – eliminates the ability to make a two-tier

offer to encourage shareholders to tender early

Dual class capitalization – more than one class of common stock

with most of the voting power privately held

Countertender offer – “Pac-man” defense, target offers to buy the

bidder

Ethics Note: In The Law and Finance of Corporate Insider Trading:

Theory and Evidence (Kluwer Publishing, 1993), Arshadi and

Eyssell argue that an active market for corporate control will be

characterized by increases in the nature and complexity of

defensive tactics and by an increasing volume of pre-

announcement insider trading. In the case of the former, managers

facing an environment that is (from their perspective) increasingly

hostile will seek to defend themselves and their positions.

Defensive tactics will be implemented, tested by takeover bids and

in the courts, and modified.

Trading on nonpublic information has been shown in numerous

academic studies to be extremely profitable (albeit illegal); thus

the conclusion that financial markets are not strong-form efficient.

In the case of takeover bids, insider trading is argued to be

particularly endemic, because of the large potential profits

involved, and because of the relatively large number of people “in

on the secret.” Managers, employees, investment bankers,

attorneys, and financial printers have all been accused in various

takeover-related insider trading cases in the 1980s.

Anecdotal evidence of the pervasiveness of takeover-related insider

trading is found in the allegations of “unusual” run-ups in the

price of Grumman’s stock just prior to Northrop’s 1994

takeover bid. This is even more remarkable when you consider the

severity of anti-insider trading legislation enacted in the 1980s.

Lecture Tip: Less common, but not rare, are “reverse mergers,” in

which a firm goes public by merging into a public shell company.

Ted Turner gained control of Rice Broadcasting (WJRJ-TV) in

1970 by doing a reverse merger. Rice Broadcasting was “virtually

insolvent,” but by merging into a public company, Turner was

obtaining financing for subsequent growth.

29.5 Have Mergers Added Value?

Slide 29.19 –

Slide 29.20 Have Mergers Added Value?

Available evidence suggests that target stockholders make significant

gains – more in tender offers than in mergers. On the other hand,

bidder stockholders earn comparatively little (breaking even on

mergers and making a few percent on tender offers).

A. Returns to Bidders

Lecture Tip: It is probably not overstating the matter to say that the

accepted wisdom in modern finance is that, in the aggregate, more

merger and acquisition activity is preferred to less. Dozens of

event studies report that, on average, the wealth of target firm

stockholders is greatly enhanced, while the wealth of acquiring

firm stockholders is unaffected, or at worst, slightly diminished.

For many, the notion that an active market for corporate control is

a good thing has become so ingrained that we are somewhat

surprised when others do not view things the same way. However,

in an interesting essay in the August 1998 issue of Harpers

magazine, Lewis H. Lapham likens the sequential announcements

of seemingly ever-larger corporate combinations to the elephant

act at the circus:

“The corporate ringmasters left out the part with the trapeze

artists and the clowns. Instead of a band they brought

accountants, introducing Jumbo or Babar to the

cameras in the hotel ballroom with a blare of press

releases – how much cash for what class of stock, the

sum of the combined assets and the disposition of the

principal executives, the fate of 12,000 superfluous

workers, the newly merged colossus proclaimed the

wonder of the age. The attending media never failed to

greet the number with a roar of superlatives (the

biggest this, the richest that), and over a period of eight

weeks so many elephants plodded in and out of the

headlines that I began to wonder how the company

mahouts would manage to fit them all under the same

tent or onto the same golf course. I didn’t take a

complete set of notes, but even a brief list of some of

the more memorable exits and entrances attests to the

great and golden truth that size matters, that big is

beautiful and biggest best of all.”

In at least one sense, Lapham is correct. The 1998 merger pace

was torrid. In the first five months of the year, $630 billion worth

of mergers and acquisitions were announced. Compare that to

1996, a record year for M&A during which activity totaled $658.8

billion for the entire year. (Interestingly, and perhaps not

surprisingly, the August 3, 1998, issue of Fortune notes that risk

arbitrage activity has “exploded,” having risen phoenix-like since

1992, when the Investment Dealers Digest asked “Is Risk

Arbitrage Dead?”) When you discuss mergers and the market for

corporate control in your Corporate Finance courses, you may

wish to hunt up Mr. Lapham’s essay to use as a starting point for

class discussion. While you may not agree with the points he

makes, it is extremely well-written and makes a compelling case

for what business strategists have advocated for many years –

getting back to the firm’s “core business” and doing it well.

A. Target Companies

B. The Managers versus the Stockholders

Agency conflict suggests that mergers may be done for purposes

other than value creation. One possibility is excess free cash is

used for empire building rather than value creation (or dividends).

For the target firm, fear of displacement may lead managers to

reject bids, thereby giving up premiums for stockholders.

29.6 The Tax Forms of Acquisitions

Slide 29.21 The Tax Forms of Acquisitions

Tax-free – acquisitions must be for a business purpose and there must

be a continuity of equity interest

Taxable – if cash or a security other than stock is used, the acquisition

is taxable

Taxable versus Tax-Free Acquisition

Capital gains effect – if taxable, the target’s shareholders may end

up paying capital gains taxes, driving up the cost of the acquisition

Write-up effect – if taxable, the target’s assets may be revalued, i.e.,

written up and depreciation increased. However, the Tax Reform

Act of 1986 made the write-up a taxable gain, making the process

less attractive.

29.7 Accounting for Acquisitions

In 2001, FASB eliminated the pooling of interest option, but, in

exchange, they also eliminated the strict amortization of goodwill.

There are no cash flow consequences stemming from the accounting

method used.

Slide 29.22 Accounting for Acquisitions

The target firm’s assets are reported at fair market value on the

bidder’s books. The difference between the assets’ market value

and the acquisition price is goodwill, which is no longer amortized,

but is reduced when the value is impaired.

Below is an additional example depicting the balance sheet effects of

the purchase method.

Example: Firm X borrows $10 million to acquire Firm Y, creating

Firm XY.

Balance Sheets (in millions) prior to the acquisition:

Firm X Firm Y

Working Capital $ 2 Debt $ 0 Working Capital $ 1 Debt $ 0

Fixed Assets 18 Equity 20 Fixed Assets 5 Equity 6

Total Assets $20 Total L&E $20 Total Assets $6 Total L&E $6

Firm Y’s fixed assets have a market value of $8 million, making total

assets worth $9 million.

Balance Sheet after the acquisition

Firm XY

Working Capital $ 3 Debt $10

Fixed Assets 26 Equity 20

Goodwill 1

Total Assets $30 Total L & E $30

29.8 Going Private and Leveraged Buyouts

Slide 29.23 Going Private and Leveraged Buyouts

Private group, usually composed of existing managers, takes the

firm private. Many are heavily financed by debt (leveraged

buyout). The added debt provides a large tax deduction and also

reduces agency costs.

29.9 Divestitures

Slide 29.24 Divestitures

Divestiture – a firm sells assets, operations, divisions, or segments

Reasons for a divestiture

1. Requirement after an acquisition for antitrust purposes

2. Unit may be unprofitable

3. Company may need the cash

4. Company may want to focus on core competency

A. Sale

The most basic divesture—simply a sale of an asset or division.

B. Spin-Off

Spin-off – parent company distributes shares of the subsidiary to

existing stockholders in the same proportion as their ownership in

the parent company.

A. Carve-Out

Equity carve-out – parent company creates a separate company of

the division in question and then arranges an IPO where a small

fraction of the company is sold to the public. The parent company

retains enough shares to maintain control.

B. Tracking Stocks

Company creates a separate stock to track the performance of a

division separate from the overall company. The firm still

maintains full control.

Slide 29.25 Quick Quiz