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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
