WEEK 4

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ECF 2222 CORPORATE FINANCE II

• WEEK 4
• VALUATING TAKEOVERS
• MERGERS

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Learning Objectives

• Evaluate suggested reasons for takeovers.
• Explain how to estimate the gains and costs of
  takeovers.
• Explain the main differences between cash and
  share-exchange takeovers.
• Outline the regulation of takeovers in Australia.
• Outline defence strategies that can be used by
  target companies.
• Outline the main findings of empirical research
  on the effects of takeovers on shareholders
  wealth.
• Outline defence strategies that can be used by
  target companies.
• Outline the main findings of empirical research
  on the effects of takeovers on shareholders
  wealth.

3
Fundamental Concepts

• Takeovers typically involve one company
  purchasing another by acquiring a controlling
  interest in its voting shares.
• Also called acquisitions and mergers.
• Market for corporate control
• A market in which alternative teams of managers
  compete for the right to control corporate
  assets.
• Such a market enables the quick redeployment of
  assets in ways expected to bring economic
  benefits to shareholders.

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Importance of Takeovers in Australia

• Important because they involve changes in the
  ownership and/or control of valuable assets.
• Table shows Ernst Young survey results on
  acquisitions by Australian listed industrial
  companies with a total market capitalisation of
  more than 30m.

Table 20.1
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Fluctuations in Takeover Activity Listed
Companies
Table 20.2
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Fluctuations in Takeover Activity

• No generally-accepted explanation for the
  existence of takeover waves.
• Evidence that takeover activity is positively
  related to the behaviour of share prices.
• Periods when share prices are increasing are also
  periods of optimism for investment.
• While companies will increase internal investment
  (new plant and equipment) they will also look for
  external investment (opportunities to take
  control of existing assets).
• Changes in legislation controlling takeovers may
  also influence the level of takeover activity.

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Fluctuations in Takeover Activity (cont.)

• Recent results from the US suggest
• Takeovers triggered by industry-level economic
  shocks force industry rationalisation.
• Acquisition followed by shutdown of marginal
  production capacity.
• Deregulation is another important source, which
  forces industry-wide rationalisation and thus is
  a catalyst for mergers and acquisitions activity.

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Types of Takeovers

• Horizontal takeover takeover of a target company
  operating in the same line of business as the
  acquiring company.
• Vertical takeover takeover of a target company
  that is either a supplier of goods to, or a
  consumer of goods produced by, the acquiring
  company.
• Conglomerate takeover takeover of a target
  company in an unrelated type of business.

9
Reasons for Takeovers

• Synergy in takeovers is the situation where the
  performance, and therefore the value, of a
  combined entity exceeds those of the previously
  separate components
• VAT gt VA VT
• where
• VAT the value of the assets of the combined
  company
• VA the value of Company A operating
  independently
• VT the value of Company T operating
  independently

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Reasons for Takeovers (cont.)

• The target company is managed inefficiently.
• The acquiring and target companies have assets
  that are complementary.
• The target company is undervalued.
• Cost reductions result.
• Increased market power.
• Diversification benefits.
• The target company or the acquiring company has
  excess liquidity or free cash flow.
• Tax benefits result.
• There are increased earnings per share and
  price-earnings ratio effects.

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Evaluation of the Reasons for Takeovers

• The Target Company is Managed Inefficiently
• The acquiring companys managers may see an
  opportunity to use the target companys resources
  more efficiently.
• Improvements in efficiency are most likely in
  horizontal takeovers, as the acquiring companys
  managers are likely to have the necessary
  expertise.

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Evaluation of the Reasons for Takeovers (cont.)

• Complementary Assets
• Sometimes either or both of the companies can
  provide the other with needed resources at
  relatively low cost.
• For example, the targets managers may be
  considered to have valuable skills, motivating a
  takeover based on acquiring expertise. It may be
  cheaper to acquire this expertise via a takeover
  than to hire and train new staff.

13
Evaluation of the Reasons for Takeovers (cont.)

• Target Company is Undervalued
• Market efficiency suggests that most managers
  will find it very difficult to identify
  undervalued companies.
• However, if share markets are not efficient in
  the strong-form sense, managers may be able to
  use private information to identify bargains.
• A takeover may also occur when the market value
  of the target company is less than the sum of the
  market values of its assets. Other managers may
  recognise the existence of alternative and better
  uses for the assets.

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Evaluation of the Reasons for Takeovers (cont.)

• Cost Reductions
• The total cost of operating the combined company
  may be expected to be less than the cost of
  operating the two companies separately.
• Cost savings may be due to economies of scale.
• Horizontal takeovers may reduce production costs.
• Vertical takeovers may reduce the costs of
  communication and of various forms of bargaining.

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Evaluation of the Reasons for Takeovers (cont.)

• Increased Market Power
• Taking over a company in the same industry may
  increase the market power of the combined
  company.
• This increase in market power may enable the
  acquiring company to earn monopoly profits if
  there are significant barriers to entry into the
  industry.
• However, various legislative measures are in
  place to prevent anti-competitive takeovers.

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Evaluation of the Reasons for Takeovers (cont.)

• Diversification Benefits
• The takeover, it is suggested, enables a company
  to reduce risk via diversification.
• However, when shareholders themselves hold
  diversified portfolios, diversification by a
  company is a neutral factor that will neither
  alter its market value nor benefit its
  shareholders.
• Combining two companies whose earnings streams
  are less than perfectly correlated will lower the
  risk of default on debt, so that the debt
  capacity of the combination is greater than the
  two separate companies.

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Evaluation of the Reasons for Takeovers (cont.)

• Excess Liquidity and Free Cash Flow
• A company with excess liquidity may be identified
  as a takeover target by companies seeking access
  to funds.
• On the other hand, companies with excess
  liquidity may turn to the acquisition of other
  companies rather than return more cash to
  shareholders.
• Such takeovers may result from managers pursuing
  their own interests ahead of the interests of
  shareholders.
• Jensen argues that companies engaging in
  takeovers of this kind are likely to become
  targets themselves.

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Evaluation of the Reasons for Takeovers (cont.)

• Tax Benefits
• Taking over a company with accumulated tax losses
  may reduce the total tax payable by the combined
  company.
• The use of past accumulated tax losses is
  restricted to situations where it can be shown
  that either the continuity-of-ownership test or
  the same-business test is satisfied.

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Evaluation of the Reasons for Takeovers (cont.)

• Tax Benefits
• Other things being equal, reduction of company
  tax will mean that resident shareholders have to
  pay more personal tax on dividends.
• Therefore, any advantage associated with lowering
  company tax payments will be only a timing
  advantage.

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Evaluation of the Reasons for Takeovers (cont.)

• Increased Earnings Per Share (EPS) and
  Price-Earnings Ratio Effects
• While acquiring companies may wish to evaluate
  the effect of a proposed takeover on their EPS,
  this is an unreliable approach.
• It is quite possible that a takeover that
  produces no economic benefits will nevertheless
  produce an immediate increase in EPS
  (bootstrapping).

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The Roles of Takeovers

• The threat of takeover can discipline the
  management of target companies.
• To be effective, threats must sometimes be
  carried out, and where significant inefficiencies
  or agency problems remain, the managers of target
  companies can be replaced by takeovers.
• Takeovers can take advantage of synergies such as
  economies of scale or complementarity between
  assets.

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Economic Evaluation of Takeovers

• The gain from the takeover can be defined as the
  difference between the value of the combined
  company and the sum of their values as
  independent entities
• Gain VAT (VA VT)

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Economic Evaluation of Takeovers (cont.)

• Assuming that cash is used to buy Company T, the
  net cost is defined as
• Net cost cash VT
• Cost is considered in terms of the premium paid
  over Ts value as an independent entity.
• The takeover will have a positive NPV for Company
  As shareholders only if the gain exceeds the net
  cost
• NPVA gain net cost
• gain cash VT gt 0

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Economic Evaluation of Takeovers (cont.)

• If NPVA is equal to zero, then the above equation
  can be used to find the value of Company T to
  Company A, VT(A), which is the maximum price A
  should pay for the target
• VT(A) cash gain VT

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Economic Evaluation of Takeovers (cont.)

• It is necessary to focus on the incremental cash
  flow effects of the takeover
• Incremental inflows
• sales revenue
• proceeds from disposal of surplus assets
• Incremental outflows
• operating costs
• capital investments to upgrade existing assets or
  acquire new assets

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EXAMPLE 20.2 (Bird et al, 2002, Pg. 676)

• i)The overall change in net operating cashflows
  will be
• 290000-70000230000450000 per annum.
• This has a PV of 450000/0.15 3 million.
• The gain will be
• Gain 3000000-400000800000-1000000
• 2400000

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• ii) The maximum price Mayfair should be prepared
  to pay is the value of Board Ltd as an
  independent entity plus the gain of 2.4m. Board
  has 5 m shares on issue which have a market price
  of 2 each. Assuming that market price equals
  value as an independent entity
• Vt 5000000 x 2 10 000 000
• And
• Vt(A) 240000010000000 12400000
• So the maximum price Mayfair should be prepared
  to pay is
• 12400000/50000002.48 per share

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Comparing Gains and Costs

• The amount of the cash consideration determines
  how the total gain is divided between the two
  sets of shareholders every additional dollar
  paid to the targets shareholders means a dollar
  less for the acquirers shareholders.

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Comparing Gains and Costs(cont.)

• Note that the possible gains from a takeover may
  already be impounded into the targets market
  price.
• Management should therefore check that the share
  price of a proposed target has not already been
  increased by takeover rumours.
• Management should also keep its takeover
  intentions completely confidential until formally
  announcing the bid.

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EXAMPLE 20.3 (Bird et al, 2002, Pg. 678)

• (a) The net cost is
• Net cost cash Vt
• 11 500 000 -10 000
  000
• 1 500 000
• This results show that Boards share holders
  capture 1.5m of the total gain associated with
  the takeover.
• (b) The NPV for Mayfairs shareholders is
• NPVa Gain net cost
• 2 400 000 - 1 500 000
• 900 000

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Estimating Cost for a Share-Exchange Takeover

• Share-exchange takeover the acquiring company
  issues shares in exchange for the targets
  shares.
• The cost will depend on the post-takeover price
  of the acquiring companys shares.

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Estimating Cost for a Share-Exchange Takeover
(cont.)

• In general, the estimated cost of a share
  exchange takeover is
• Net cost b VAT VT
• where b the fraction of the combined company
  that will be owned by the former
  shareholders of the target company
• For a cash offer, the net cost is independent of
  the takeover gain, whereas for a share-exchange
  offer, the cost depends on the takeover gain.

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EXAMPLE 20.4 (Bird et al, 2002, Pg. 679)

• Based on these terms, Mayfair appears to be
  paying 2.30 per share for Board so it might seem
  that the net cost would remain at 1.5m.
  However, the net cost depends on the value of the
  Mayfair shares issued to boards shareholders and
  this depends on Mayfairs share price after the
  takeover is announced. The value of the combined
  company can be found by
• Vat Va Vt gain
• 20 000 000 x 4.60 10 000
  000 2 400 000
• After the takeover, the number of Mayfair shares
  on issue will be 20 million 2.5 million and the
  value of the shares issued to acquire Board is
• (2.5/22.5) x 104400000 11 600 000
• If board is worth 10 million as an independent
  entity, the net cost of acquiring Board is
• 11 600 000 - 10 000 000 1600
  000

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Alternate ValuationValuation Based on Earnings

• The bidder values the target by first estimating
  the future earnings per share (EPS) of the
  target.
• The EPS figure is then multiplied by an
  appropriate price/earnings (P/E) ratio to
  obtain an implied price (valuation) of the target.

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Alternate Valuation Valuation Based on Assets

• A companys equity can be valued by deducting its
  total liabilities from the sum of the market
  values of its assets.
• May be appropriate where a bidder intends to sell
  many of the targets assets, or where the company
  has been operating at a loss.

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Valuation Based on Assets (cont.)

• Criticisms
• Balance-sheet figures based on historical cost
  are unlikely to provide a reliable guide to
  market values.
• Intangible assets may not be included in the
  balance sheet.
• There may be complementarity between assets so
  that the total market value of the assets may be
  greater than the sum of their individual values.

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Regulation of Takeovers

• The main legislation is chapter 6 of the
  Corporations Act 2001.
• Australian Securities and Investments Commission
  (ASIC) administers the Corporations Act.
• ASIC has some discretion and can apply to the
  Corporations and Securities Panel if an
  acquisition is believed to be inappropriate.

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Regulation of Takeovers (cont.)

• The most important aspect of the Corporations Act
  is that unless the procedures laid down in
  chapter 6 are followed, the acquisition of
  additional shares in a company is virtually
  prohibited if this would
• result in a shareholder being entitled to more
  than 20 per cent of the voting shares, or
• increase the voting shares held by a party that
  already holds 20-90 per cent of the voting shares
  of the company.

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Regulation of Takeovers Off-Market Bid

• This type of offer must remain open for between 1
  and 12 months and may be for100 per cent, or a
  specified proportion, of each holders shares.
• Steps of an Off-Market Bid
• Bidders Statement must be lodged with ASIC.
• Bidders Statement sent to holders of bid class
  securities.
• Target informed of bid.
• The target must respond with Targets Statement,
  recommending whether the offer should be accepted.

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Regulation of Takeovers Market Bids

• Market Bid offer to acquire shares of listed
  target company, up to a specified bid price.
• Bid cannot be conditional, must be in cash and
  for a period between 1 and 12 months.
• The offerer must supply ASIC, the ASX and the
  target company and its shareholders with Bid
  Statement.
• The target replies to all parties with a Target
  Statement.

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Regulation of Takeovers Disclosure Requirements

• Corporations Act has provisions for disclosure by
  bidders and targets.
• Some examples of bidder information includes
  bidders identity, bidders intentions for
  target, sources of funding, a prospectus where
  securities are issued as consideration.
• Target statement must include information that
  would help shareholders decide whether to accept
  or not, including directors recommendation.
• If bidder is related, experts report.

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Other Controls on Takeovers

• Legislation other than Corporations Act may
  affect takeovers
• Trade Practices Act competition.
• Foreign Acquisitions and Takeovers Act Federal
  Treasurer has the power to prohibit takeovers by
  foreign companies.
• Industry-related legislation media ownership
  laws, four pillars banking policy.
• ASX listing rules secrecy during takeover
  discussions, or apply for trading halt, shares
  cannot be placed for 3 months after receiving
  takeover offer.

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Takeover Defences

• Defence measures are of two basic types
• Pre-emptive measures.
• Strategies employed after a bid is received.
• Pre-emptive Measures
• Arranging interlocking shareholdings.
• Amend the companys Constitution in ways that
  make the company less attractive to a potential
  bidder.
• E.g. the Constitution may contain self-destruct
  provisions (poison pills).

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Takeover Defences (cont.)

• Defence Strategies employed after a bid is
  received
• Acquisition by friendly parties
• Disclosure of favourable information.
• Claims and appeals

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Takeover Defences (cont.)

• Effects of Takeover Defences
• Defence tactics used during Australian takeovers
  bids were successful in 70 per cent of cases
  between 1981 and 1985.
• The resistance by target directors is, therefore,
  a key factor in determining the outcome of
  takeovers.
• It is also important that management ensures that
  their recommendation is consistent with their
  responsibilities to shareholders.

46
Empirical Evidence on Takeovers Target Company

• Target company shareholders earn significant
  positive abnormal returns.
• Brown and da Silva Rosa (1997) average abnormal
  return of 25.5 per cent over the 7-month period
  around the takeover announcement.
• Casey, Dodd and Dolan reported significant
  abnormal returns on target company shares around
  the time that significant shareholding notices
  were filed.

47
Empirical Evidence on Takeovers Target Company

• The initial increase in wealth of the target
  companys shareholders appears to be maintained,
  even where the bid is unsuccessful.
• The bid may have prompted a change in the target
  companys investment strategy, which is expected
  to improve performance.
• Information released during the bid caused the
  market to revalue the shares.
• The market may expect a further bid for the
  target company.

48
Empirical Evidence on Takeovers Acquiring Company

• On average, the shareholders of acquiring
  companies earn positive abnormal returns in the
  years before the takeover bid is made.
• This suggests that takeover bids are typically
  made by companies that have been doing well, and
  have demonstrated an ability to manage assets and
  growth.

49
Empirical Evidence on Takeovers Acquiring
Company (cont.)

• Many studies have found that around the time of
  the announcement, the average abnormal returns to
  shareholders of bidding companies is close to
  zero and, in some cases, negative.
• Jarrell and Poulsen identified three general
  explanations for the negligible wealth effects
  for acquiring company shareholders
• Takeovers are profitable, but the wealth effects
  are disguised.
• Competition depresses returns to acquirers.
• Takeovers are neutral or poor investments.

50
Empirical Evidence on Takeovers Acquiring
Company (cont.)

• The Wealth Effects of Takeovers are Disguised
• An acquiring company is typically much larger
  than a target company, so while there may be a
  worthwhile dollar gain to shareholders, the gain
  is small relative to the total value of the
  company.
• When a company has a known strategy of growth by
  acquisition, the expected gains from this
  strategy may already be reflected in the
  companys share price.
• Announcement effects that are small or negative
  may also reflect market reaction to the financing
  of the takeover.

51
Empirical Evidence on Takeovers Acquiring
Company (cont.)

• Competition
• Returns to successful bidders are likely to be
  lower if a takeover is resisted by target
  management, or contested by multiple bidders.
• Returns to acquiring companies when there are
  multiple bidders are insignificantly different
  from zero.
• Returns to acquiring companies when there is only
  one bidder are significantly positive.

52
Empirical Evidence on Takeovers Acquiring
Company (cont.)

• Takeovers are Neutral or Poor Investments
• Rolls Hubris Hypothesis managers of acquiring
  companies are supremely confident that their
  ability to value other companies is better than
  that of the market.
• Consequently, they pay more for companies than
  they are worth.
• The large returns to target shareholders
  represent wealth transfers from the shareholders
  of acquiring companies.

53
Empirical Evidence on Takeovers Are Takeovers
Poor Investments?

• Bradley, Desai and Kim (1988)
• Found an average gain of 117 million, or 7.4
  per cent, in the combined wealth of shareholders.
• Their results support the hypothesis that
  takeovers yield real, synergistic gains and do
  not support Rolls wealth transfer hypothesis.
• However, they found for some types of
  acquisitions there were consistent losses to
  acquiring company shareholders.

54
Empirical Evidence on Takeovers Are Takeovers
Poor Investments? (cont.)

• Andrade, Mitchell and Stafford (2001)
• US event study, found large abnormal returns to
  target company shareholders.
• No significant effect to bidder company
  shareholders.
• Overall shareholder wealth effect is positive and
  significant.
• Also found that method of payment was important.
• Gains are larger when paid in cash, no overall
  effect when paid in acquirers shares.

55
Empirical Evidence on Takeovers Are Takeovers
Poor Investments? (cont.)

• Long-term abnormal returns.
• Loughran and Vijh (1997) US study finds
  differences between announcement period
  (short-term) returns and long-term returns to
  takeovers.
• 5 year abnormal returns differed depending on
  form of payment.
• Share offers had returns of 24 per cent, cash
  offers had returns of 18.5 per cent.
• Related to hostility of takeover.
• Brown and da Silva Rosa (1998) Australian study
  finds no long-term abnormal returns.

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Distinguishing Between Good and Bad Takeovers

• Rolls hubris hypothesis
• Managers pay too much for target companies
  because they overestimate their ability to run
  them.
• Managers may pursue their own objectives rather
  than those of their shareholders
• Often the result of free cash flow problems.
• Some managers may make unprofitable takeovers
  simply because they are poor managers
• Such managers are possibly seeking other fields
  in which they hope to perform better.

57
Distinguishing Between Good and Bad Takeovers
(cont.)

• Evidence
• Lang, Stulz and Walking (1989) using Tobins q
  ratio as a measure of managerial performance
• found takeovers involving an acquirer with high q
  and a target with a low q produced large gains
  and
• takeovers involving an acquirer with a low q and
  a target with a high q produced losses to
  shareholders.

58
Distinguishing Between Good and Bad Takeovers
(cont.)

• Mitchell and Lehn (1990)
• Results suggest the stock market is able to
  distinguish between good and bad bidders.
• Results consistent with the argument that one
  role of takeovers is to discipline managers who
  fail to maximise profits, including those that
  make value-reducing takeovers.
• Morck, Shleifer and Vishny (1990)
• Found that acquiring companies do systematically
  pay too much in takeovers in which the benefits
  for managers are particularly large.

59
The Net Effects of Takeovers (cont.)

• McDougall and Round (1986)
• Found no evidence of benefits such as improved
  profitability or reduction of risk.
• However, this study was criticised due to various
  problems in using accounting data.
• Healy, Palepu and Ruback (1992)
• Used both accounting data and share price data
  and focused on operating cash flows before
  interest and tax to minimise the problems with
  accounting data.
• Their results provided further evidence that
  mergers do result in improved performance.

60
The Sources of Gains From Takeovers

• Market Myopia
• Investors are preoccupied with short-term
  earnings performance and will undervalue
  companies that undertake long-term developments,
  making them prime targets for takeovers.
• Empirical evidence soundly rejects this
  hypothesis.

61
The Sources of Gains From Takeovers (cont.)

• Tax Benefits
• Appear to have at least a minor role in
  motivating takeover activity.
• Healy, Palepu and Ruback (1992)
• Gains are primarily from increased asset
  productivity.
• Some evidence of lower labour costs.

62
The Sources of Gains From Takeovers (cont.)

• Jensens survey of US evidence
• Takeovers benefit shareholders of target
  companies.
• Acquiring company shareholders earn, on average,
  about 4 per cent in hostile takeovers, and
  roughly zero in mergers, although these returns
  seem to have declined from past levels.
• Takeovers do not waste credit or resources.
  Instead, they generate substantial gains
  historically 8 per cent of the total value of
  both companies.

63
The Sources of Gains From Takeovers (cont.)

• Jensens survey of US evidence
• Actions by managers that eliminate or prevent
  offers or mergers are the ones most likely to be
  harmful to shareholders.
• Takeover gains do not result from the creation of
  monopoly power.

64
Summary

• Takeovers are an important part of the market for
  corporate control.
• Like any investment, a takeover should proceed
  only if it has a positive NPV.
• Takeover activity in Australia can be erratic
  industry shocks, including deregulation, play an
  important role.
• Three main types of takeover horizontal,
  vertical and conglomerate.
• Many reasons for takeovers include
• assets can be used more efficiently under new
  management.
• Synergistic gains.
• Diversification and EPS benefits dubious.
• Takeovers regulated by Corporations Act, intends
  that all parties are treated fairly and have
  enough information to make a fully informed
  decision.
• Value-enhancing corporate restructures include
  divestitures, spin-offs and buyouts.

65
Summary (cont.)

• Evidence shows that target company shareholders
  gain, bidding company shareholders do not gain as
  much, if at all.
• Takeovers paid for in shares tend to be less
  successful for the acquiring company, seeming to
  benefit managers interests, indicating problems
  with agency costs.
• Recent US evidence shows that mergers do lead to
  improved asset performance, efficiency, rather
  than solely wealth redistribution.