Finance Chapter 21 The Target Managers Want Negotiate The Highest

Unlock access to all the studying documents.

View Full Document

546

Chapter 21 Mergers, Acquisitions, and Corporate Control

Chapter Overview

The Opening Focus discusses the 2007 bid by Australia’s BHP Billiton Limited’s for Brit-

ain’s Rio Tinto plc. This hostile takeover attempt, if successful, would have been the third largest

Opening Focus Discussion Questions

1. Where are the synergies, or cost savings, expected from the merger? Why might bigger seem

to be better for media companies and many other firms?

2. Can you describe other business decisions or business experiences in which there appears to be

a financial “home run,” yet politics or other human concerns has the potential to void the deal?

This chapter looks at:

21-1. Merger Waves and International Acquisition Activity

21-2. Why Do Companies Make Acquisitions?

Technology

1. Smart Ideas Video. James Brickley of the University of Utah looks at the potential benefit of

antitakeover provisions to shareholders.

3. Smart Ideas Video. Claire Crutchley of Auburn University explains that joint ventures can be

beneficial to shareholders.

5. Smart Ideas Video. Francesca Cornelli of the London Business School looks at risk arbitrage

as a successful component of a takeover.

6. Smart Practices Video. David Baum of Goldman Sachs discusses poison pills, measures

which are taken by a company to discourage hostile takeovers.

Chapter 21 Mergers, Acquisitions and Corporate Control

547

Lecture Guide

This chapter provides an overview to mergers and acquisitions, introducing new terminol-

21-1 Merger Waves and International Activity

Mergers have come in waves – periods of high and low popularity. Merger activity has

been impacted by changes in regulations concerning mergers.

crease in the last decade. The following figures show the greatest areas of activity.

Figure 21.1 Trends in M&A: Total Value of M&A Transactions in the U.S. Hit and All-Time

High in 2000.

Figure 21.2 Value of Cross-Border Transactions Involving U.S. Firms in 2010

Figure 21.3 Merger Transactions by Region (1998-2003)

21-2 Why Do Companies Make Acquisitions?

The purpose of mergers and/or acquisitions is to create value. This section helps answer the

21-2a Explaining Mergers and Acquisitions

A merger should occur only if it creates value. This can be related back to the equation for

cash flows from a firm. The merger must increase revenues, reduce costs, reduce taxes, reduce

working capital or fixed asset needs. If the two firms do not create more value together rather than

apart, then the merger should not be undertaken. Firms may wish to merge to increase their poten-

548 Instructor’s Manual

Firms may want to maximize their managerial expertise. For example, RJR Nabisco purchased

Kraft Foods with the intent of having Kraft’s expert food managers take charge of their Nabisco

foods operations.

Mergers may have financial purposes. If a large, high-rated company purchases a heavily debt

ridden, low rating, high debt cost company, it could immediately refinance the acquired firm’s junk

bonds, achieving a lower rate of interest and lower interest expense.

This section discusses in detail the major reasons for mergers and acquisitions:

• Growth: Mergers are a common motive for a firm to grow because if firms do not contin-

ue to grow, they will stagnate and eventually die.

21-2b Calculation of the Effect of a Merger on Earning Per Share

This section discusses and illustrates the formula for determining post-merger EPS. It also in-

cludes an example.

21-3 Do Mergers Create Value?

The value created in a merger will be realized in the form of a premium to acquired com-

21-3a Merger Valuation Methods

This section discusses the following most common merger valuation methods:

• Discounted Cash Flow: As discussed in previous chapters, DCF values the firm on the ba-

sis of discounted future expected cash flows.

Chapter 21 Mergers, Acquisitions and Corporate Control

549

23-b Stockholder Gains (or Losses) in Mergers-Returns to Bidder and Target

This section discusses the valued gained to shareholders during a merger/acquisition. Much

Table 21.2 Abnormal Returns to Target and Bidders in a Two-Day Window

21-3c Method of Payment

The method for which payment in made in a merger or acquisition can be of significance.

A pure stock exchange only involves the exchange of the bidder’s stock for the target’s stock. This

Figure 21.8 Mergers by Financing Mix

Table 21.3 Abnormal Returns to Targets and Bidders in Two-Day Window Conditional on

Method of Payment (Tender Offers in SDC, 2000-2010)

21-3d Returns to Bondholders

21-3e How Do Target CEOs Make Out?

21-4 Merger and Acquisition Transaction Details

21-4a Types of Mergers

This section discusses the many types of mergers and acquisitions. This section also de-

tails some of the terminology concerning merged firms after the merger. Some of fully integrated

and no longer exist as a separate name or entity (statutory merger), while other retain their own

550 Instructor’s Manual

• Student Involvement: Ask students why a proxy contest, whether successful or unsuccess-

21-4b LBOs, MBOs, and Recapitalizations

In a “going private” transaction, a formerly public firm becomes private, generally after a

21-4c Takeover Defenses and Divestitures

This section defines anti-takeover defense terminology – steps a firm can take to discourage

takeovers. Many firms have anti-takeover measures in place. In general, these are considered to be

anti-shareholder, since shareholders generally realize a premium, often a substantial premium,

when one company is purchased by another. In one extreme case, when the Pennsylvania-based

Armstrong World Industries was the object of a possible takeover by the Canadian Belzberg broth-

ers, the Pennsylvania state legislature passed a law practically speaking making hostile takeovers

impossible in the state. Lawmakers were concerned that jobs and revenues would leave the state

and were explicitly looking out for the interests of employees, customers and suppliers, rather than

putting shareholders first.

• Student Involvement: Ask students why firm’s management might want anti-takeover pro-

visions – about 50% of managers of the acquired firm lose their jobs following a takeover.

This potential job insecurity might encourage managers to discourage takeovers. On the

other hand, shareholders frequently benefit from a corporate takeover, in the firm of a high

control premium. How can the firm prevent such conflicts of interest between managers

and shareholders?

Not all corporate control actions make the firm larger. Firms may choose to make themselves

Table 21.4 Commonly Used Antitakeover Devices

21-5 Accounting Treatment of Mergers and Acquisitions

The newest accounting requirements for acquisitions were published at the end of 2008.

Chapter 21 Mergers, Acquisitions and Corporate Control

551

21-6 Regulation of Mergers and Acquisitions

21-6a Antitrust Regulation

These sections outline the major laws concerning antitrust enforcements. Since large mergers

can reduce competition they are watched carefully. The Department of Justice has established mer-

Table 21.5 Determination of Anticompetitiveness—Using the Herfindahl-Hirschman Index

(HHI)

21-6b The Williams Act

The Williams Act slowed down merger activity by making a quick “raid” of another com-

21-6c International Regulation of Mergers and Acquisitions

International agencies are now taking a greater interest in mergers and acquisitions. This

21-6d Other Legal Issues Concerning Corporate Control

The market for corporate control is a way of keeping managers working as efficiently as

possible. If a company is not well run, its stock price will become depressed and it will be a more

21-7 Corporate Governance

This section covers the duties and obligations of the board of directors during a merger or

acquisition.

Mergers, Acquisitions and Corporate Control Summary

This section quickly summarizes the main points of this chapter.

552 Instructor’s Manual

Ch. 21 Resource Articles

“Scoring Boards on Governance Has its Risks,” Wall Street Journal, October 2, 2002. This article

looks at new firms which offer corporate governance research services, now that many investors, in

particular institutional investors, are focusing more on corporate governance.

“Where Have the Masters of the Big Mergers Gone?” Wall Street Journal, June 25, 2002. This

Enrichment Exercises

Darden (University of Virginia) has several excellent negotiating merger exercises, where students

represent the various parties to a negotiation. The cases are:

From Robert F Bruner, Case Studies in Finance, 4th edition:

#40 Chrysler Corporation: Negotiations between Daimler and Chrysler

From Robert F Bruner, Case Studies in Finance, 3rd edition:

Show students excerpts from the movie, “Other People’s Money.” In the movie, Danny DeVito

attempts to takeover Gregory Peck’s wire and cable business. From a Hollywood point of view,

Gregory Peck is the hero, valiantly defending his company from a heartless corporate raider. From

a finance point of view, Danny DeVito is the good guy – creating shareholders value and prevent-

ing the firm from continuing to take on negative net present value projects.

Answers to Concept Review Questions

1. Merger waves tend to be positively related to high growth rates in the overall economy and to

industry shocks, or industry-wide events such as deregulation that affect the corporate control

activities of entire industries. The first merger wave was in 1897, largely the result of a grow-

ing emphasis on a national economy rather than a grouping of regional economies. With more

interstate commerce, corporations sought expansion and market power through expansion mer-

gers. Merger activity ended with the stock market crash of 1904. Another merger wave began

Chapter 21 Mergers, Acquisitions and Corporate Control

553

2. Within a region, barriers to doing a productive deal are likely to be much lower….by barriers is

3. Value maximizing motives include increasing operating profit, realizing gains from restructur-

4. In a publicly traded company, investors opinions on an acquisition are immediately known by

the effect the acquisition has on the stock price. Further, if the predicted value that is to be at-

5. A manager might pursue conglomerate mergers or mergers for corporate diversification be-

cause of agency conflicts. A manager is concerned about total risk – his or her personal wealth

and job security. The more diversified the company, the better able it will be to weather market

6. The target managers want to negotiate the highest possible price, so they will argue that prece-

7. Even if synergies make the target much more valuable to the bidder than it is as a standalone

entity, if the bidder is much larger than the target, any gains from the deal will be relatively

554 Instructor’s Manual

8. A statutory merger is when the acquired firm disappears completely as an entity. This is com-

mon when the “brand” or name of the target company has no value to the acquiring company.

9. A tender offer involves one company (the bidder) making a public offer to purchase all of the

shares of the target company that the target’s shareholders are willing to “tender.” This is a

10. The two most important methods of paying for corporate acquisitions are with cash and using

11. Target shareholders almost always win in a corporate takeover, but acquirers’ returns are

mixed. Bhagat, Dong, Hirshleifer, and Noah (2005) finds that the average announcement–

period abnormal return for the shareholders of firms launching successful tender offers is very

close to zero for their entire 1962-2001 study periods, with these average returns fluctuating

12. With implementation of Financial Accounting Standards Board (FASB) Statement 141 and the

near-concurrent (December 31, 2001) Statement 142, there now exists one standard method of

accounting for mergers. Under these new standards, target liabilities remain unchanged, but

target assets are “written up” to reflect current market values, and the equity of the target is re-

Chapter 21 Mergers, Acquisitions and Corporate Control

555

13. Companies that have few tangible assets, but tremendous growth prospects can have acquisi-

tion values that will be above the fair market value of the assets. New technology companies

14. This answer can change depending on economic/political conditions. However, companies that

15. The dynamic interpretation of antitrust laws affects managers’ acquisition strategies. Some-

17. The Herfindahl Index (HI) demonstrates the relationship between corporate focus and share-

holder wealth. The HI is computed as the sum of the squared percentages, in this case the pro-

portion of revenues derived from each line of business. Thus, the HI exaggerates the difference

18. Mergers are classified by degree of business concentration to see if a merger will result in too

19. Corporate governance refers to how companies are governed, that is, the processes and rules

that affect who ultimately makes the decisions in a company. In theory, these rules should

Answers to End-of-Chapter Questions

Q21-1. What is meant by a change in corporate control? List and describe the various ways in

which a change of corporate control may occur.

556 Instructor’s Manual

A21-1. Corporate control refers to the monitoring, supervision and direction of a corporation. A

change in corporate control can occur when two firms merge, or through

• a leveraged buyout or management buyout, when third parties or management buy all

Q21-2. What is a tender offer, and how can it be used as a mechanism to orchestrate a merger?

A21-2. In a tender offer, one corporation asks shareholders of another corporation to sell, or ten-

Q21-3. Distinguish between the different levels of business concentration created by mergers. Ex-

plain how the changing business environment has caused an evolution in the classification

of concentration from the original FTC classification, to the abbreviated FTC classifica-

tion, and now to the measures of overlap and focus.

A21-3. A horizontal merger is a combination of competitors within the same geographic market.

A market extension merger is a combination of firms that produce the same product in dif-

ferent geographic markets. Advances in technology and transportation have made the geo-

graphic classification less meaningful. Horizontal mergers now refer to mergers between

Q21-4. Elaborate on the significance of the mode of payment for the stockholders of the target

firm and their continued interest in the surviving firm. Specifically, which form of payment

retains the stockholders of the target firm as stockholders in the surviving firm? Which

payment form receives preferential tax treatment?

A21-4. Mergers can be paid for using cash, an exchange of stock in the acquired firm for stock in

Chapter 21 Mergers, Acquisitions and Corporate Control

557

Q21-5. What is the signaling theory of mergers? What is the relationship between signaling and the

mode of payment used in acquisitions? Is there a relationship between the mode of pay-

ment used in acquisitions and the level of insider shareholdings of acquiring firms?

A21-5. The signaling theory states that the mode of payment offered by acquiring firms signals

Q21-6. Empirically, what are the wealth effects of corporate control activities? Who wins and who

loses in corporate control contests? What explanations or theories are offered for the dif-

ferences in returns of acquiring firms’ common stocks? Why are higher takeover premiums

paid in cash transactions than in stock transactions? How do other security holders fare in

takeovers?

A21-6. Target firm shareholders receive large wealth gains from the premium received for giving

up control of the firm. On average, common stockholders of acquiring firms experience

positive returns in successful tender offers and virtually zero returns in successful mergers.

558 Instructor’s Manual

Q21-7. Describe several different motives for mergers. Are each of these motives likely to increase

bidder value?

A21-7. The single most compelling motive for a merger is growth that will lead to additional val-

ue. Under the idea of “synergy”, when two firms combine, economies of scale or scope are

created that allow for total production to occur at a lower cost. Other synergies allow for

Q21-8. Define the types of synergy that may result from mergers. What are the sources of these

synergies?

A21-8. Synergies that might result from a merger include:

• Operational synergy, results of economies of scale and scope and complementary re-

sources.

Q21-9. Explain how agency problems may lead to non-value-maximizing motives for mergers.

Discuss the various academic theories offered as the rationale for these agency problem–

induced motives.

A21-9. Sometimes managers gain from mergers, rather than shareholders. According to the man-

agerialism theory of mergers, poorly monitored managers will pursue mergers to maxim-

ize their corporation’s asset size because managerial compensation is usually based on

Chapter 21 Mergers, Acquisitions and Corporate Control

559

Q21-10. Why does the Precedent Transactions valuation method typically yield higher valuations?

A21-10. Precedent transaction multiples are based on completed M&A transactions where a buyer

acquires control (sometimes complete control) of a target. Implicit in most acquisitions is

Q21-11. Would a large technology company and a large conglomerate (that operates in many in-

dustries) be good comparable firms for a multiples-based valuation? Why or why not?

A21-11. Just because two companies are the same size does not mean they are comparable from a

Q21-12. Describe the relationship between conglomerate mergers and portfolio theory. What is the

desired result of merging two unrelated businesses? Has the empirical evidence proven

corporate diversification to be successful?

A21-12. Corporate diversification is not considered a value-maximizing merger strategy. The

premise of corporate diversification is that the combination of two businesses with less

than perfectly correlated cash flows will create a merged firm with less volatile cash flows

Q21-13. List the federal laws regulating antitrust and anticompetitive mergers. What are the actions

governed by each law? How do the regulatory agencies determine anticompetitiveness?

A21-13. The main antitrust laws are:

• Sherman Antitrust Act of 1890, forbidding anticompetitive mergers

Q21-14. What is the purpose of the Williams Act? What are the specific provisions of the act?