Mergers and Acquisitions

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Mergers and Acquisitions
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Merger activity in 2000-01
Source Mergers and Acquisitions
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Types of transactions

• Mergers, acquisitions, takeovers and buyouts are
  types of transactions that change the ownership
  of firms
• During the period 1980-2000, the distribution of
  such transactions among US nonfinancial firms was
  as follows
• There were 4,686 mergers, acquisitions and
  takeovers worth 3,258 billion in aggregate
  market equity value
• There were 465 buyouts worth 60 billion
• There were 337 reverse buyouts worth 65 billion

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• A merger is the complete absorption of one firm
  by another and in this scenario we refer to an
  acquisition that takes place in friendly terms
• The acquiring firm retains its identity and
  acquires all the assets and liabilities of the
  acquired firm that ceases to exist and, thus,
  such transactions are also called acquisitions
  (e.g. the acquisition of McDonnell Douglas by
  Boeing)
• In a consolidation, both firms cease to exist and
  a new firm is created after the acquisition (e.g.
  Peco Energy and Unicom merged to form the new
  utility firm Exelon)

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• In the typical merger, the stockholders of the
  ceased firm receive either cash or shares in the
  surviving firm
• The acquiring firm makes an offer to the
  stockholders of the acquired (or target) firm to
  purchase their shares through cash, shares in the
  new firm or both
• Another form of an acquisition is for the
  acquiring firm to purchase all the assets of the
  acquired firm, but this may be a costly procedure

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• Acquisitions can be
• Horizontal a firm acquires another firm in the
  same industry (Daimler Chrysler in 1998)
• Vertical a firm acquires another firm in a
  different stage (backward or forward) of the
  production process (GM - Fisher Body)
• Conglomerate (merger) combination of two firms
  in unrelated industries (Mobil Oil Montgomery
  Ward in 1974)
• A takeover is the purchase of one firm by another
  firm
• If the takeover is friendly, then it is basically
  an acquisition, but if not, then it is known as
  hostile takeover (IBMs acquisition of Lotus in
  1995 Oracles bid for PeopleSoft in 2003)

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Mechanics of MAs

• Antitrust Law
• Proposed merger must pass scrutiny by the
  Department of Justice and the Federal Trade
  Commission (FTC)
• Clayton Act (1914) forbids acquisitions that may
  substantially lessen competition or tend to
  create a monopoly
• The government may forbid a merger, or require
  the parties to divest some assets before the
  merger is completed in order to lessen market
  power in a particular sector

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• MA accounting
• From an accounting standpoint, a merger or
  acquisition can be treated as a purchase of
  assets or a pooling of interests
• Under the pooling of interest approach
• Stock is exchanged between the two firms
• The balance sheet of the merged firm is nothing
  more than the two separate balance sheets added
  together

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• Under the purchase of assets method, the
  acquiring firm buys the target firm using cash
• If the acquiring firm pays a premium over the
  target firms book value (e.g. for intangible
  assets, such as a promising new technology
  developed by the target), the difference is
  booked against goodwill
• Goodwill has to amortized and these charges
  reduce reported income, which most firms do not
  like and that is why the pooling of interests
  method is typically preferred

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• Tax issues
• An acquisition may be taxable or tax-free
• In a taxable acquisition, the shareholders of the
  target firm pay taxes on capital gains because
  they have sold their shares
• In a tax-free acquisition, the shareholders of
  the target firm who have exchanged their shares
  are assumed to have no capital gains or losses,
  as long as they continue to have a stake in the
  new firm

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Reasons for MAs

• Economies of scale from horizontal mergers (e.g.
  BP and Amoco expected to save 2 bn annually from
  operations)
• Economies of scope from vertical mergers
  (integrate suppliers, such as in the case of GM
  and Delphi, but recent trend is towards
  outsourcing)
• Complementarities a small firm may have a unique
  product, but may need the experience in marketing
  and sales of a mature firm that may also be in
  need of new products

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• Unused tax shields a firm may acquire another
  (loss-making) firm to take advantage of tax-loss
  carry-forwards (IRS will object if this is only
  reason for merger)
• Excess cash/inefficiencies
• A firm with excess cash can use it better by
  acquiring another firm with good projects a firm
  with excess cash can also become a target of an
  acquisition if it is not investing the cash in
  positive NPV projects
• Acquisitions can also eliminate inefficiencies
  frequently related to bad management

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Other (not so good) reasons for MAs

• The target firm tries to avoid bankruptcy and
  chooses to be acquired (evidence shows these
  acquisitions not to be successful)
• The Hubris Hypothesis the acquiring firms
  management overvalue their ability to create
  value once they take control of the target firms
  assets
• Managers motivations to build an empire may lead
  to several acquisitions that end up destroy value
  (e.g. WorldCom)

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Gains from MAs

• MAs imply gains for the acquiring firm if there
  are synergies involved
• This implies that there should be incremental net
  gains so that the value of the combined firm will
  be greater than the sum of the two stand-alone
  firms
• The incremental net gains (synergies) are given
  by
• ?V V12 (V1 V2)

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• The net incremental gains are shown by estimating
  the incremental cash flows from the acquisition,
  which are
• ?FCF ?EBIT ?Depreciation - ?Tax - ?Capital
• ?Revenue - ?Cost - ?Tax - ?Capital
• Benefits of MAs arise from
• ? Revenues (improved marketing, increased market
  power, strategic gains from entering new
  industry)
• ? Costs, taxes, cap. requirements (economies of
  scale and/or scope, better use of resources of
  another firm, benefits of tax shield, lower
  investment needs due to higher efficiency)

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How much does an acquisition cost?

• To determine the cost of an acquisition, we must
  calculate how much a firm has to give up in order
  to acquire another firm
• The incremental net gain to firm 1 from acquiring
  firm 2 is given by
• ?V V12 (V1 V2)
• The value of firm 2 to firm 1 is
• V2 V2 ?V

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• Therefore, firm 1 should proceed with the
  acquisition if the NPV is positive
• NPV V2 - C gt 0
• where C gives the cost to firm 1 of acquiring
  firm 2
• Firm 1 has two options choose a cash acquisition
  or a stock acquisition

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Case 1 Costs of a cash acquisition

• Suppose we have the following information about
  firms 1 and 2 and that firm 1 is considering
  acquiring firm 2

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• Assume that
• Both firms are 100 equity owned
• The incremental net gain to firm 1 from acquiring
  firm 2 is 100
• Firm 2 has decided not to sell for less than 150
  (100 firm value 50 acquisition premium)
• The value of firm 2 to firm 1 is
• V2 V2 ?V 100 100 200
• The NPV of the cash acquisition is 200 - 150
  50
• After the acquisition, firm 1s value increases
  by 50 to 550 (500 was initial value) and firm
  2s stockholders have captured 50 out of the
  100 merger gains
• Firm 1 continues to have 25 share and each share
  will be worth 550/25 22, meaning a gain of 2
  per share

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Case 2 Costs of a stock acquisition

• In a stock acquisition, the stockholders of firm
  2 exchange their shares for shares in the new
  firm
• The merged firm will be worth
• V12 V1 V2 ?V 500 100 100 700
• Since firm 2s stockholders want to sell the firm
  for 150 they will receive 150 worth of shares
  from firm 1 or 150/20 7.5 shares given the
  price of firm 1s shares

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• The new firm has 25 7.5 32.5 shares worth
  700 meaning a value per share of 700/32.5
  21.54, which is lower because firm 2s
  stockholders also own part of the new firm
• What was the cost of acquiring form 2 to firm 1?
  Was it only 150?
• The 7.5 shares of the merged firm owned by firm
  2s stockholders are worth 7.5 ? 21.54 161.55
• The NPV of the stock acquisition is
• NPV V2 - C 200 - 161.55 38.45
• which is lower than the NPV of the cash
  acquisition because firm 2s stockholders share
  some of the gains (but also the losses)

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• Implications of cash or stock acquisitions
• Using cash to finance an acquisition (merger)
  implies that the cost is unaffected by the merger
  gains
• Using stock is preferred if there is potential
  for overvaluation or undervaluation of either
  firm (e.g. if firm 1 overvalues firm 2 and pays
  more, the bad news from discovering this fact in
  the future will be shared by both firm 1s and
  firm 2s stockholders)

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Market Reaction to Mergers

• Empirical evidence has shown that upon
  announcement of a merger bid, on average
• Share price of the targeted company rise 16
• Share price of acquiring company are essentially
  unchanged (a fall of 0.7)
• Value of total package (buyer plus seller) rises
  on average by 1.8
• Sellers earn higher returns because
• Buyers are typically substantially much larger
  firms that the significant gains from the merger
  do not affect the firms share price
• More importantly, it is often the case that there
  is a competition among bidders, which increases
  the gains for the target firm

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Takeovers

• Most MAs are friendly and negotiated by the two
  firms managements and boards
• If a friendly acquisition is not possible and the
  acquiring firm wants to take control of the
  target firm, the acquiring firm can
• Try to get the support of the target firms
  stockholders in the next annual meeting (proxy
  fight)
• Go directly to the target firms stockholders and
  make them a tender offer to sell their shares

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Motives for takeovers

• Failure of target firms management may attract
  corporate raiders
• Firms that have grown as a result of inefficient
  diversification may become targets of a bust-up
  takeover where the firms assets are divested so
  that it becomes more focused and efficient
• Based on the hubris hypothesis, the target firms
  management may resist the takeover because they
  do not accept the argument that the acquiring
  firms management can run the firm better

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Takeover defenses

• Pre-offer defenses
• Some firms adopt so-called shark-repellent
  charter amendments to deter potential bidders
• Staggered boards (board is staggered in groups
  with only one group elected each year, thus
  making it more difficult for bidders to gain
  control)
• Require supermajority (above 80) to approve a
  merger
• Restrict mergers unless a fair price is received
• Unwelcome acquirers must wait a number of years
  before a merger can be completed

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• Other pre-offer defenses include
• Poison pills Existing shareholders are issued
  the right to buy stock at a discount if there is
  a significant purchase of shares by an outside
  bidder
• Poison put Bondholders can demand repayment if
  there is a hostile takeover
• Post-offer defenses
• Issue new shares or repurchase shares from
  shareholders at a premium
• Buy assets that the bidder does not want or that
  can create antitrust problems

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• To eliminate resistance from management, the
  stockholders of the target firm may offer their
  managers a golden parachute
• This is a generous payoff if the managers lose
  their job after the takeover
• This benefits of the takeover will outweigh this
  cost for stockholders in such a scenario