Merger and Acquisitions

Chapter 21
Mergers and Acquisitions
 Types of Mergers
 Merger Analysis
 Role of Investment Bankers
 Corporate Alliances
 Private Equity Investments and
Divestitures
Introduction
 Corporate restructuring
includes the activities
involving expansion or
contraction of a firm’s
operations or changes in its
asset or financial (ownership)
structure.
Corporate Restructuring
 1960s - Mergers of unrelated

firms formed huge
conglomerates.
 1980s - Investors purchased
conglomerates and sold off
the pieces as independent
companies.
 1990s - Strategic mergers of

related firms to create
synergies.
Merger Fundamentals
 A merger is defined as the

combination of two or more
firms, in which the resulting
firm maintains the identity of
one of the firms, usually the
larger one.
Merger Fundamentals
 When one company takes

over another and establishes
itself as the owner, the
purchase is called an
acquisition.
Merger Fundamentals
 Consolidation is the
combination of two or more
firms to form a completely
new corporation.
Merger Fundamentals
 Is the concept of merger and

acquisition in corporate law
the same under the Philippine
Competition Act (PCA)?
Merger Fundamentals
 The PCA defines a merger as

“the joining of two or more
entities into an existing entity
or to form a new entity.”
 It basically adopts the concept
of merger as traditionally
understood in corporate law.
Merger Fundamentals
 But unlike corporate law

which distinguishes between
merger and consolidation, the
PCA includes consolidation in
the concept of merger.
Merger Fundamentals
 The acquiring company is

the firm in a merger
transaction that attempts to
acquire another firm.
 The target company in a
merger transaction is the firm
that the acquiring company is
pursuing.
Merger Fundamentals
 A strategic merger is a
transaction undertaken to
achieve economies of scale.
Merger Fundamentals
 A financial merger is a
merger transaction
undertaken with the goal of
restructuring the acquired
company to improve its cash
flow and unlock its hidden
value.
Merger Fundamentals
 While mergers should be

undertaken to improve a
firm’s share value, mergers
are used for a variety of
reasons as well.
Motives for Merger
 The overriding goal for

merging is the maximization
of the owners’ wealth as
reflected in the acquirer’s
share price.
Motives for Merger
 Synergy: value of the whole

exceeds sum of the parts.
Operating economies
Financial economies
Differential management
efficiency
Increased market power
Motives for Merger
 Combining
Complementary Resources
Merging may result in each
firm filling in the “missing
pieces” of their firm Firm A
with pieces from the

other firm. Firm B
Motives for Merger
 Mergers as a Use for

Surplus Funds
For a firm in a mature
industry with few, if any,
positive NPV projects
available, acquisition may be
the best use of funds.
Motives for Merger
 Firms may also combine to

enhance their fund-raising
ability when a “cash rich” firm
merges with a “cash poor” firm.
A cash-poor firm merging with a
cash-rich firm will be able to
accept more positive NPV
projects.
Motives for Merger
 Break-up value: assets would

be more valuable if sold to
some other company.
What are some questionable
reasons for mergers?
 Diversification
 Purchase of assets at below
replacement cost
 Get bigger using debt-
financed mergers to help fight
off takeovers
Motives for Merger
• Synergy
• Growth
Creating
• Increasing market power
Value
• Acquiring unique capabilities or resources
• Unlocking hidden value
• Exploiting market imperfections
• Overcoming adverse government policy
Cross-Border
• Technology transfer
Mergers
• Product differentiation
• Following clients
• Diversification
Dubious • Bootstrapping earnings
Motives • Managers’ personal incentives
• Tax considerations
Change Forces Driving Mergers
 Technological change – impact

of computers and the internet
resulted in new industries and
firms
 Efficiency of operations
 Changes in industry organization
 New industries.
 Globalization and freer trade

Technological developments
in transportation and
communications
Europe and other regions
move toward common
markets
 Deregulation and regulation

telecom, energy, airlines, etc.
 Favorable economic and
financial conditions
Rising stock prices and P/E
ratios
Low interest rate levels
 Negative trends in industries

and economies
 Widening inequalities in income
and wealth
 High valuation of equities
Merger Fundamentals
 A holding company is a
corporation that has voting
control of one or more other
corporations.
 Subsidiaries are the
companies controlled by a
holding company.
Types of Mergers
 A horizontal merger is a
merger of two firms in the
same line of business.
 A vertical merger is a
merger in which a firm
acquires a supplier or a
customer.
Horizontal Mergers
 Between firms in same business

 Rationale
Economies of scale and scope
Synergies (combining of best
practices)
 Government regulation due to
potential anticompetitive effects
Vertical Mergers
 Combinations between firms

at different stages
 Goal is information and
transaction efficiency
Types of Mergers
 A conglomerate merger is
a merger combining firms in
unrelated businesses.
Types of Mergers
 A congeneric merger is a
merger in which one firm
acquires another firm that is
in the same general industry
but neither in the same line of
business nor a supplier or a
customer.
Merger Fundamentals
 A friendly merger is a
merger transaction endorsed
by the target firm’s
management, approved by its
stockholders, and easily
consummated.
Merger Fundamentals
 A hostile merger is a merger

not supported by the target
firm’s management.
Target firm’s management
resists the merger.
Merger Fundamentals
 In a hostile merger, the

acquiring company gain
control of the firm by buying
shares in the marketplace.
Acquirer must go directly to
the target firm’s stockholders
and try to get 51% to tender
their shares.
Merger Fundamentals
 Often, mergers that start out

hostile end up as friendly
when offer price is raised.
Mindset of Managers – Merger
Friendly merger: Offer Hostile merger:
made through the target’s Offer made directly to
board of directors the target
Approach target management.
shareholders
Enter into merger discussions.
Types
Perform due diligence.
• Bear hug
Enter into a definitive merger
agreement. • Tender offer
• Proxy fight
Shareholders and regulators
approve.
Negotiating Mergers
 Mergers are generally

facilitated by investment
bankers—financial
intermediaries hired by
acquirers (or sellers) to find
suitable target (or buyers)
companies.
Negotiating Mergers
 Once a target has been

selected, the investment
banker negotiates with its
management or investment
banker.
Functions of Investment Bankers in
Mergers
 Arranging mergers
 Assisting in defensive tactics
 Establishing a fair value
 Financing mergers
 Risk arbitrage
Negotiating Mergers
• Reasons given for the merger

– Economies of scale in PC industry
– Projected synergies of $2.5 billion
– Strategic response to conditions in
computer and information
technology sectors
• Market reaction to 9/3/01
announcement
– Hewlett-Packard declined 19%
– Compaq fell by 10%
Negotiating Mergers
• Major events in the merger

process
–CEOs initiated discussion in
June 2001 – firms then
undertook extensive due
diligence
–Consulting firms McKinsey and
Accenture were involved in the
analysis of the merger
Negotiating Mergers
• Major events in the merger process

– Goldman Sachs (HP) and Salomon
Smith Barney (Compaq) were
engaged in July 2001, to provide
financial advice
– Members of Hewlett and Packard
families threatened to vote against
the merger
– Shareholders approve in May 2002
Negotiating Mergers
 An initial offer, subject to the

findings of a special audit, is
made and a memorandum of
agreement (MOU) is crafted.
Negotiating Mergers
 If negotiations break down,

the acquirer will often make
a direct appeal to the target
firm’s shareholders using a
tender offer.
Negotiating Mergers
 A tender offer is a formal

offer to purchase a given
number of shares at a
specified price, with the
objective of gaining control
of the company.
Negotiating Mergers
 The tender offer is made to

all shareholders at a
premium above the
prevailing market price.
 In general, a desirable target
normally receives more than
one offer.
Negotiating Mergers
 A tender offer allows the

acquiring company to bypass
the management of the
company it wishes to
acquire.
Negotiating Mergers
 Normally, non-financial issues

such as those relating to
existing management,
product-line policies,
financing policies, and the
independence of the target
firm must first be resolved.
Negotiating Mergers
 In many cases, existing

target company management
will implement takeover
defensive actions to ward
off the hostile takeover.
Negotiating Mergers
 Some takeover defensive

actions:
informing stockholders that
the offer is not in their best
interests,
taking legal actions,
Negotiating Mergers
 Some takeover defensive

actions:
increasing the cash dividend
or declaring a stock split to
gain shareholder support,
acquiring another company
Negotiating Mergers
 The white knight strategy

is a takeover defense in
which the target firm finds
an acquirer more to its liking
than the initial hostile
acquirer and prompts the
two to compete to take over
the firm.
Negotiating Mergers
 A poison pill is a takeover

defense in which a firm
issues securities that give
holders rights that become
effective when a takeover is
attempted.
Negotiating Mergers
 Greenmail is a takeover
defense in which a target
firm repurchases a large
block of its own stock at a
premium to end a hostile
takeover by those
shareholders.
Negotiating Mergers
 Leveraged recapitalization
is a takeover defense in which
the target firm pays a large
debt-financed cash dividend,
increasing the firm’s financial
leverage in order to deter a
takeover attempt.
Negotiating Mergers
 Golden parachutes are

provisions in the employment
contracts of key executives
that provide them with
sizeable compensation if the
firm is taken over.
Negotiating Mergers
 Shark repellants are anti-

takeover amendments to a
corporate charter that
constrain the firm’s ability to
transfer managerial control
of the firm as a result of a
merger.
Corporate Alliances
 Corporate or strategic
alliance is a cooperative
deal that stops short of a
merger.
Corporate Alliances
 Alliances allow firms to

create combinations that
focus on specific business
lines.
Marketing strategies
Joint ownership of worldwide
operations
Corporate Alliances
 A joint venture is a
corporate alliance in which
two or more independent
firms combine their resources
to achieve a specific, limited
objective.
LBOs and Divestitures
 A leveraged buyout (LBO)

is an acquisition technique
involving the use of a large
amount of debt to purchase
a firm.
 LBOs are a good example of

a financial merger
undertaken to create a high-
debt private corporation with
improved cash flow and
value.
 In a typical LBO, 90% or

more of the purchase price is
financed with debt where
much of the debt is secured
by the acquired firm’s assets.
 And because of the high risk,
lenders take a portion of the
firm’s equity.
 An attractive candidate for

acquisition through an LBO
should possess three basic
attributes:
 It must have a good

position in its industry
with a solid profit history and
reasonable expectations of
growth.
 It should have a relatively

low level of debt and a high
level of “bankable” assets
that can be used as loan
collateral.
 It must have stable and

predictable cash flows
that are adequate to meet
interest and principal
payments on the debt and
provide adequate working
capital.
 Other attributes an attractive

candidate for acquisition
through an LBO should
possess:
 The company has gone

through a program of heavy
capital expenditures (i.e.,
modern plant).
 Less cyclical product sales.
 Experienced and quality
management.
 There are subsidiary assets

that can be sold without
adversely impacting the core
business, and the proceeds
can be used to service the
debt burden.
• LBO Characteristics:
–Financial buyer purchases
company using high level of
debt financing
–Financial buyer replaces top
management
–New management improves
operations
–Financial buyer makes public
offering of improved firm
• A divestiture is the selling of
an operating unit for various
strategic motives.
• An operating unit is a part of
a business, such as a plant,
division, product line, or
subsidiary, that contributes to
the actual operations of the
firm.
• Unlike business failure, the
motive for divestiture is often
positive:
–to generate cash for
expansion of other product
lines,
–to get rid of a poorly
performing operation,
• Unlike business failure, the
motive for divestiture is often
positive:
–to streamline the corporation,
or
–to restructure the
corporation’s business
consistent with its strategic
goals.
• Divestitures in General
–Involuntary divestiture
usually is the result of an
antitrust ruling by the
government
–Voluntary divestiture is a
willful decision by
management to divest
• Divestitures in General
–Include sell-offs, spin-offs
and equity carve-outs
–Efficiency gains and refocus
–Reverse synergy (4 - 2 = 3)
–Strategic change by the
company
• Spin-off -- Separating a
subsidiary from its parent
company, with no change in
equity ownership.
• The parent firm no longer
has control over the
subsidiary.
• Spin-off -- A form of divestiture
resulting in a division or
operating unit becoming an
independent company.
• Ordinarily, shares in the new
company are distributed to the
parent company’s
shareholders on a pro rata
basis.
• Sell-off -- Selling a firm’s
subsidiary or division to
another company.
• Liquidation -- Selling assets
to another company and
distributing the proceeds
from the sale to
shareholders.
• Equity Carve-out -- The public
sale of stock in a subsidiary in
which the parent usually
retains majority control.
–Similar to spin offs, except that
shares in the new company are
not given to existing
shareholders but sold in a
public offering.
• Going Private -- A group of
private investors buys all of a
firm’s publicly-traded stock.
• The firm is now private, and
its shares are no longer
traded in the secondary
market.
• Methods used by firms to divest:
–Sale of a product line to
another firm
–Sale of the unit to existing
management
–Through a spin-off
–Liquidation of the operating
unit’s individual assets
• Regardless of the method or

motive used, the goal of
divesting is to create a more
lean and focused operation
that will enhance the efficiency
and profitability of the firm to
enhance shareholder value.
• Research has shown that for
many firm’s the breakup value
—the sum of the values of a
firm’s operating units if each is
sold separately—is significantly
greater than their combined
value.
• However, finance theory has thus
far been unable to adequately
explain why this is the case.
Analyzing and Negotiating Mergers:
Valuing the Target Company
 The valuation of a target firm

requires a deep appreciation
of the factors that affect the
combined operations of the
target and acquiring firm.
 The acquiring firm is not

assured of a gain if it ends
up paying too high a price for
the target firm.
 The valuation of the target
firm is one of the most
critical issues in mergers.
 Approaches in determining the
value of the target include:
Value the existing assets at
their current values.
Project and discount the
future cash earnings of a
target firm (DCF method).
 In practice, a combination is
usually arrived at during the
final negotiations.
 In determining the value of
the target, the acquiring firm
conducts a due diligence
audit of its accounts and
operation.
 Determining the value of a
target may be accomplished
by applying the capital
budgeting techniques.
 These techniques should be
applied whether the target is
being acquired for its assets
or as a going concern.
Merger Analysis:
Post-Merger Cash Flow Statements
2012 2013 2014 2015
Net sales $60.0 $90.0 $112.5 $127.5
- Cost of goods sold 36.0 54.0 67.5 76.5
- Selling/admin exp 4.5 6.0 7.5 9.0
- Interest expense 3.0 4.5 4.5 6.0
EBT 16.5 25.5 33.0 36.0
- Taxes 6.6 10.2 13.2 14.4
Net income 9.9 15.3 19.8 21.6
Retentions 0.0 7.5 6.0 4.5
Cash flow 9.9 7.8 13.8 17.1
Why is interest expense included in the
analysis?
 Debt associated with a

merger is more complex than
the single issue of new debt
associated with a normal
capital project.
analysis?
 Acquiring firms often assume

the debt of the target firm,
so old debt at different
coupon rates is often part of
the deal.
analysis?
 The acquisition is often

financed partially by debt.
 If the subsidiary is to grow in
the future, new debt will
have to be issued over time
to support the expansion.
Why are earnings retentions deducted
in the analysis?
 If the subsidiary is to grow,

not all income may be
assumed by the parent firm.
 Like any other company, the
subsidiary must reinvest
some its earnings to sustain
growth.
What is the appropriate discount rate to
apply to the target’s cash flows?
 Estimated cash flows are

residuals which belong to the
acquirer’s shareholders.
 They are riskier than the
typical capital budgeting cash
flows.
 Because fixed interest

charges are deducted, this
increases the volatility of the
residual cash flows.
 They should be discounted

using the cost of equity
rather than the WACC,
because the cash flows are
risky equity flows.
Discounting the Target’s Cash Flows
 The cash flows reflect the

target’s business risk, not the
acquiring company’s.
 However, the merger will
affect the target’s leverage
and tax rate, hence its
financial risk.
Calculating Continuing Value
 Find the appropriate discount

rate.
rs(Target) =rRF +(rM  rRF )b Target
= 9%+(4%)(1.3) =14.2%
Calculating Continuing Value
 Determine the continuing

(terminal) value.
Continuing value 2015  CF2015 (1  g) /(rs  g)
 $17.1(1.06) /(0.142  0.06)
 $221 .0 million
Net Cash Flow Stream
2012 2013 2014 2015

Annual cash flow $9.9 $7.8 $13.8 $ 17.1
Continuing value 221.0
Cash flow $9.9 $7.8 $13.8 $238.1
 Value of target firm

Solve for NPV = $163.9 million
Would another acquiring company
obtain the same value?
 No. The input estimates
would be different, and
different synergies would
lead to different cash flow
forecasts.
 Also, a different financing
mix or tax rate would change
the discount rate.
The Target Firm Has 10 Million Shares
Outstanding at a Price of $9.00 / Share
 What should the offering

price be?
 The acquirer estimates the
maximum price they would
be willing to pay by dividing
the target’s value by its
number of shares:.
The Target Firm Has 10 Million Shares
Outstanding at a Price of $9.00 / Share
Max. price  Target's value/# of shares

 $163.9 million/10 million
 $16.39
 Offering range is between $9

and $16.39 per share.
Making the Offer
 At $9 all the merger benefits

would go to the acquirer’s
shareholders.
 At $16.39, all value added
would go to the target’s
shareholders.
Making the Offer
 Acquiring and target firms

must decide how much
wealth they are willing to
forego.
Shareholder Wealth in a Merger
Shareholders’ Bargaining
Wealth Range
Acquirer Target
$9.00 $16.39
Price Paid
for Target
0 5 10 15 20
Evaluating Bids
 The acquiring firm

shareholders want to
minimize the amount paid to
target shareholders, not
paying more than the pre-
merger value of the target
plus the value of the
synergies.
Evaluating Bids
 The target shareholders want

to maximize the gain,
accepting nothing below the
pre-merger market value.
Shareholder Wealth
 Nothing magic about

crossover price from the
graph.
 Actual price would be
determined by bargaining.
Shareholder Wealth
 Higher if target is in better

bargaining position, lower if
acquirer is.
 If target is good fit for many
acquirers, other firms will
come in, price will be bid up.
If not, could be close to $9.
Shareholder Wealth
 Acquirer might want to make

high “preemptive” bid to
ward off other bidders, or
make a low bid and then
plan to increase it.
 It all depends upon its
strategy.
Shareholder Wealth
 Do target’s managers have

51% of stock and want to
remain in control?
 What kind of personal deal
will target’s managers get?
Advantages of Using the DCF Method
 The model allows for changes

in cash flows in the future.
 The cash flows and estimated
value are based on forecasted
fundamentals.
 The model can be adapted for
different situations.
Disadvantages of Using the
DCF Method
 For a rapidly growing
company, the FCF and net
income may be misaligned
(e.g., higher-than-normal
capital expenditure).
 Estimating future cash flows
is difficult because of the
uncertainty.
DCF Method
 Estimating discount rates is
difficult, and these rates may
change over time.
 The terminal value estimate
is sensitive to the
assumptions and model
used.
Advantages of Using the
Market Multiple Analysis
 Does not require specific
estimation of a takeover
premium.
 Based on recent market
transactions, so information
is current and observed
 Reduces litigation risk.
Market Multiple Analysis
 Depends on takeover
transactions being correct
valuations.
 There may not be sufficient
transactions to observe the
valuations
 Does not include value of
Do mergers really create value?
 Acquisitions do create value

as a result of economies of
scale, other synergies,
and/or better management.
 Shareholders of target firms
reap most of the benefits,
because of competitive bids.
Analyzing and Negotiating Mergers
 After determining the value

of a target, the acquirer must
develop a proposed
financing package.
 The simplest but least
common method is a pure
cash purchase.
Stock Swap Transactions
 Another method is a stock

swap transaction which is
an acquisition method in
which the acquiring firm
exchanges shares for the
shares of the target company
according to some
predetermined ratio.
 This ratio affects the various
financial yardsticks that are
used by existing and
prospective shareholders to
value the merged firm’s
shares.
 To do this, the acquirer must

have a sufficient number of
shares to complete the
transaction.
Factors Influencing Method of Payment
 Sharing of risk among the

acquirer and target
shareholders.
 Signaling by the acquiring
firm.
 Capital structure of the
acquiring firm.

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Chapter 21

Mergers and Acquisitions

 1960s - Mergers of unrelated

 1990s - Strategic mergers of

 A merger is defined as the

 When one company takes

 Is the concept of merger and

 The PCA defines a merger as

 But unlike corporate law

 The acquiring company is

 While mergers should be

 The overriding goal for

 Synergy: value of the whole

with pieces from the

 Mergers as a Use for

 Firms may also combine to

 Break-up value: assets would

 Technological change – impact

 Globalization and freer trade

 Deregulation and regulation

 Negative trends in industries

 Between firms in same business

 Combinations between firms

 A hostile merger is a merger

 In a hostile merger, the

 Often, mergers that start out

 Mergers are generally

 Once a target has been

• Reasons given for the merger

• Major events in the merger

• Major events in the merger process

 An initial offer, subject to the

 If negotiations break down,

 A tender offer is a formal

 The tender offer is made to

 A tender offer allows the

 Normally, non-financial issues

 In many cases, existing

 Some takeover defensive

 Some takeover defensive

 The white knight strategy

 A poison pill is a takeover

 Golden parachutes are

 Shark repellants are anti-

 Alliances allow firms to

 A leveraged buyout (LBO)

 LBOs are a good example of

 In a typical LBO, 90% or

 An attractive candidate for

 It must have a good

 It should have a relatively

 It must have stable and

 Other attributes an attractive

 The company has gone

 There are subsidiary assets

• Regardless of the method or

 The valuation of a target firm

 The acquiring firm is not