Chapter 22: Mergers and Acquisitions

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Topic Mergers and Acquisitions
Objectives

• Understand types of acquisitions
• Explain why it may make sense for companies to
  merge
• Estimates the gains and costs of mergers to the
  acquiring firm

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Legal Forms of Acquisitions

• Merger The complete absorption of one company by
  another, where the acquiring firm retains its
  identity and the acquired firm ceases to exist as
  a separate entity.
• Consolidation A merger in which a new firm is
  created and both the acquired and acquiring firms
  cease to exist.
• Acquisition of Stock The purchase of a firms
  voting stock in exchange for cash, shares of
  stock, or other securities.
• Acquisition of Assets A firm can effectively
  acquire another firm by buying most or all of its
  assets and the target firm does not necessarily
  cease to exist.

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Acquisition Classifications

• Horizontal Acquisition
• - Acquisition of a firm in the same industry as
  the bidder. This is an acquisition of a rival
  firm.
• (One Swiss banks buys another UBS bought SBC)
• Vertical Acquisition
• - Involves firms at different steps of the
  production process. For example, one firm buys
  its primary input supplier (AOL bought Netscape)
• Conglomerate Acquisition
• - acquisitions between companies in unrelated
  lines of business (Federated Department stores
  were acquired by Campeau Corporation)

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Gains from Acquisition

• Synergy The positive incremental net gain
  associated with the combination of two firms
  through a merger or acquisition. Merger makes
  sense only if
• VAB gt VA VB
• The incremental net gain from the merger is
• ?V VAB (VA VB)
• When ?V is positive, the merger is said to
  generate synergy. If Firm A buys Firm B, it gets
  a company worth VB plus the incremental gain ?V .
  Thus, the value of Firm B to Firm A is VB VB
  ?V

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Gains from Acquisition

• Revenue enhancement The combined firm may
  generate greater revenues than two separate firms
  due to
• Marketing gains
• Strategic benefits
• Market power
• Cost reductions The combined firm may operate
  more efficiently than two separate firms due to
• Economies of scale (spreading overheard sharing
  of central facilities, such as HQ)
• Economies of vertical integration (easier
  coordination of activities)
• Complementary resources

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Gains from Acquisition

• Tax gains are another powerful incentive for some
  acquisitions
• The use of tax losses (a firm that loses money on
  a pre-tax basis does not pay taxes, making it an
  attractive for a partner with high tax
  liabilities)
• The use of unused debt capacity (can use acquired
  firm to increase debt and generate tax shields)
• The use of surplus funds (if free cash flow is
  paid to investors as dividends it is taxed why
  not use the money to buy a firm instead)
• The ability to write up the value of depreciable
  assets (so tax deductions from depreciation are
  higher)

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Avoiding Mistakes in Evaluating an Acquisition

• Do not ignore market values (dont estimate the
  market value of a traded company, which is
  already observable)
• Estimate only incremental cash flows (only these
  cash flows add value)
• Use the correct discount rate (this is the
  required rate of return on the incremental cash
  flow. Typically use the cost of capital of the
  acquired firm, because the incremental cash flows
  are coming from this firm)
• Be aware of transaction costs (fees to investment
  bankers, legal fees, and disclosure requirements)

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The Cost of An Acquisition

• The net incremental gain to a merger is
• ?V VAB (VA VB)
• The total value of Firm B to Firm A is
• VB VB ?V
• The NPV of the merger is therefore
• NPV VB Cost to Firm A of the acquisition

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The Merger Decision

• Cost to Firm A of the acquisition
• -Cash offer Cost cash paid
• -Share offer Cost shares used ? post merger
  share price
• Cash Offer Example VA 20 million, VB 5
  million, VAB 30 million, firm A offers 6
  million in cash
• The cost of the acquisition is thus 6 million
• NPV 5M 30M - (20M 5M) - 6M 4M

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Example A

• Daytime, Inc., wants to acquire Nitetime, Ltd.,
  because it feels the whole can be more than the
  sum of the parts. Savings from the merger are
  estimated to be a one-time after-tax benefit of
  100 million. Nitetime has 5 million shares
  outstanding at a current market price of 60 per
  share. What is the maximum cash price per share
  that could be paid for
• Nitetime?
• NPV 5,000,000 x 60 100M cost in cash 0
• So the maximum cost in cash is 400M
• So the maximum price per share is 400M/5M shares
  80

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Example B

• Hot Foods, which has 1 million shares
  outstanding, wishes to merge with
• Cold Drinks with 2 million shares outstanding.
  The market prices for HF
• and CD are 40 and 15 per share, respectively.
  The merger could create
• an estimated savings of 600,000 annually for the
  indefinite future. If HF
• were willing to pay 20 per share for CD, and the
  appropriate cost of
• capital is 12 percent, what would be the
• (1) Present value of the merger gain?
• (2) Net cost of the cash offer?
• (3) NPV of the offer?

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• HF CD
• Price per share 40 15
• shares 1M 2M
• Market value 40M 30M
• PV of ?V 600,000/.12 5M
• VB VB PV of ?V 30M 5M 35M
• Cost of the offer 20 x 2,000,000 40M
• NPV of offer 35 - 40M -5M

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Cash versus Common Stock

• The distinction between cash and common share
  financing in a merger is an important one.
• If cash is used, the cost of an acquisition is
  not dependent on the acquisition gains, and the
  selling firms shareholders do not participate in
  the potential gains (or losses) of the merger.
• If common stock is used, then the selling firms
  shareholders share in the potential gains (or
  losses) of the merger.
• Acquisition by cash usually results in a taxable
  transaction, while acquisition by exchanging
  stock is generally tax free.
• Acquisition by cash does not affect the control
  of the acquiring firm. Acquisition with voting
  shares does affect it.

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Example

• A TV News Corp, Bushy Fox seeks to acquire the TV
  programme maker Bleeding Hearts. You have the
  following information

BF knows that analysts expect the earnings and
dividends of BH (current dividends are 1.75 per
year) to grow at the constant rate of 3 per
year. BF believes that acquiring BH will increase
this growth rate to 5. a) What is the value of
BH to BF? b) What would BFs gain from
acquisition be? c) If BF were to offer 30 per
share for BH, what would the NPV of the
acquisition be? d) What is the most BF would pay
for each share of BH? e) What kind of acquisition
is this?
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Calculators

• Graphics calculators will NOT be allowed in the
  exam. If the only calculator you bring to the
  exam is a graphics calculator, you will have to
  do the exam without a calculator, which will have
  dreadful consequences for your final grade.
• Remember it is your responsibility to bring the
  correct type of calculator to the exam.