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
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
LO1. Firms engage in mergers for financial motives and to increase operating efficiency. Tax
benefits and other factors must also be considered.
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LO2. Companies may be acquired through cash purchases or by one company exchanging its
shares for another company’s shares.
LO4. The diversification benefits of a merger should be evaluated.
LO5. Some buyouts are unfriendly and are strongly opposed by the potential candidates.
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Annotated Outline and Strategy
PPT Largest Mergers from 2010 to 2018 (Table 20-1)
PPT Mergers & Acquisitions North America (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.
B. Financial Motives: It is often cheaper to acquire market share than it is to develop it.
1. Portfolio Effect
2. Access to Financial Markets
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.
4. Obtain a tax loss carryforward to offset future income.
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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. Nonfinancial Motives
1. Expand management and marketing capabilities.
2. Acquire new products.
D. Motives of Selling Stockholders
2. Provides opportunity to diversify their holdings.
4. Avoid the bias against smaller businesses.
Perspective 20-1: Mergers provide an opportunity to reexamine 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
1. Capital budgeting decision: Net present value of purchasing a going concern
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
1. Emphasizes the impact of the merger on earnings per share.
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acquired firm, there will be an immediate increase in earnings per share.
PPT Financial Data on Potential Merging Firms (Table 20-2)
5. An acquired firm may have a low P/E ratio because its future rate of growth
6. The acquisition of a firm with a higher P/E ratio causes an immediate
7. Determinants of earnings per share impact of a merger
a. Exchange ratio
b. Relative growth rates
c. Relative size of the firms
PPT Postmerger Earnings per Share (Table 20-3)
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
III. Accounting Considerations in Mergers and Acquisitions
A. Prior to 2001, a merger was treated as either a pooling of interests or a purchase of
B. Criteria for pooling of interests treatment before 2001.
1. The acquiring firm issues only common stock, with rights identical to its old
3. The merged firm does not intend to dispose of a significant portion of the
assets of the combined companies within two years.
1. Necessary when the tender offer is in cash, bonds, preferred stock, or
common stock with restricted rights.
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.
IV. Negotiated versus Tender Offers
PPT Mergers & Acquisitions Hostile Takeovers (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. Takeover tender offers occur when proposed mergers are opposed by the
management of candidate firms.
B. Unfriendly takeover attempts have resulted in additions to the Wall Street vocabulary
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1. Saturday night special—a surprise offer made right before the market closes
for the weekend.
3. Leveraged takeover—the acquiring firm negotiates a loan based on the target
C. Actions by target companies to avoid unwanted takeovers.
1. White knight arrangements.
3. Buying up company’s own stock to reduce amount available for takeover.
5. Increasing dividends to keep stockholders happy.
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 by-product of corporate mergers: although each company has an
V. Premium Offers and Stock Price Movements: The acquiring firm typically pays a merger
premium of between 40 and 60 percent over the premerger market price of the firm being
acquired.
Perspective 20-3: Table 20-4 demonstrates the stock movement of potential acquirees. This is a
PPT Stock Movement of Potential Acquirees (Table 20-4)
VI. Two-Step Buyout
A. The acquiring firm attempts to gain control by offering a very high cash price for 51
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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
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.
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)