Mergers & Acquisitions

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 Mergers and Acquisitions
• Vertical merger: forward or backward
integration
• Horizontal merger: expansion in a particular
business line
• Conglomerate merger: combination of
companies from unrelated business lines

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 Value Related Reasons for M&A

• Synergism
• Taxes
• Information Asymmetry
• Agency Costs

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 Synergism

• Synergism: Whole is worth more than sum of its

parts (M&A math is 2 + 2 = 5)
– Economies of scale – lower costs by combining operations
• Using excess capacity
• Spreading fixed costs over larger volume
– Economies of scope – can carry out more activities
profitably
• Producing similar products
• Backward integration – buying a supplier to reduce costs
• Forward integration – moving control one step closer to
customers
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 Synergism (Continued)

– Economies of financing – larger companies can

raise money more economically
• The more money raised, the lower the issuance costs
on a per dollar raised
• Higher liquidity for the securities reducing cost of
issuance to the firm
– Risk reduction – lower unsystematic risk will
reduce expected bankruptcy costs
– Market power – larger market share allows
control over price
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 Taxes
• A merger can reduce the tax of a combined firm
because:
1. The acquirer has large cash flows with limited opportunities
– returning cash to shareholders exposes them to taxes
2. Revaluing assets of the target can create depreciation
expense for tax purposes
3. Losses of a target that have been carried forward can be
used by the combined firm
4. Alternative Minimum Tax might encourage acquisitions by
reducing overall tax payment for firms if they are combined
5. Diversification through M&A can increase debt capacity
increasing tax shield
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 Information Asymmetry
• Acquiring company posses information that is
not available to the investors
• Buying another company implies that the
acquiring firm managers have found a
“bargain”

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 Agency Costs
• M&A allows inefficient managers to be
replaced
• Activities in the takeover market curb the
agency cost

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Management Related Reasons for Mergers

• Reduction of Unsystematic Risk

• Takeover Risk
• Size Preference
• Hubris Hypothesis

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 Reduction of Unsystematic Risk
• Diversification at the firm level will reduce the
unsystematic risk
– Previously this was good because lower
unsystematic risk reduces expected bankruptcy
costs
– Managers also benefit form lower unsystematic
risk because lower variability in earnings increases
job security and stabilizes compensation

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 Takeover Risk
• If a company is target for a proposed
acquisition then the target can make it
difficult by acquiring another – hard to
swallow
• A defensive acquisition can create a
regulatory hurdle for the original suitor as well

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 Size Preference
• Managers’ self fulfilling prophecies – bigger is
better not necessarily profitable
• Larger firm can provide more compensation
for managers

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 Hubris Hypothesis
• Hubris hypothesis suggest that acquiring firm
managers rely too much on their abilities to
identify, undertake, and manage potential
targets
• Usual outcome of such acquisitions is a
disaster admitted by divestitures

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 M&A Process

• Identify a Target
• Valuation
• Mode of Acquisition
• Mode of Payment
• Accounting of Acquisition
– Note: Regulators (Federal Trade Commission –
FTC) can block a deal or require substantial asset
sell off
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 M&A Process (Continued)
• Identify a Target:
– Based on a sound strategy that can increase
shareholders’ wealth
– Focus on “Value Related Reasons”
– Acquisitions are usually initiated by the acquiring
firm
– Sometimes a target can announce that it is for
sale

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 M&A Process (Continued)
• Valuation:
• Net Cash Flow:
EBIT x (1 – tax rate)
+ depreciation and other non-cash expenses
– acquisition of new assets
+ increases in liabilities other than LTD
= Net cash flow
• Equity Residual Cash Flow:
Net Income
– preferred dividends
+ depreciation and other non-cash expenses
– acquisition of new assets
+ increases (– decreases) in liabilities
+ increases (– decreases) in preferred stocks
= Equity residual cash flow
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 M&A Process (Continued)

• Valuation:
– Should not ignore the value of strategic options and
payment terms
– In general an acquisition creates wealth for the
acquirer if: What Acquirer Gets

[Target Alone + Synergies + Other]

>= What Acquirer Gives

[Cash Paid + Stock Paid + Debt Assumed]

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 M&A Process (Continued)
• Mode of Acquisition:
– Refers to whether a proposed acquisition is friendly or hostile
to target managers
• Friendly acquisitions are approved by board of directors
of each firm
• Then shareholders vote on the proposal
• If no negotiation possibility exists then an acquirer can
proceed with a tender offer to target shareholders –
making it hostile
• Hostile takeover can be quite time consuming especially
when target managers fight against the tender offer
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 M&A Process (Continued)
• Mode of Payment:
– How an acquisition is paid for: cash, stock or
mixed
• If the stock is believed to be undervalued,
then stock should not be used for payment
• If the stock is overvalued then the stock
payment should/can be used

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 Takeover Defense
• Golden parachute
– A contract designed to give executives substantial
compensation if they are dismissed following a
takeover
• Poison pills, flip-over rights allowing holders to
receive stock in the acquirer if the bidder
acquires 100% of the target
• Poison pills, flip-in rights allowing holders to
receive stock in the target
– It is effective against raiders who seek to acquire
controlling interest
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 Takeover Defense (Continued)

• Poison puts
– Bond issues that become due if unfriendly
takeover occurs
• Greenmail
– Managers of target buys shares purchased by
acquirer at a substantial premium
• White knight
– A third company acquiring the target with friendly
terms
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 Accounting Method

• There used to be two methods: Pooling of

Interest and Purchase method for acquisitions
• Pooling of Interest:
– It can be used if payment is made in the form of
acquirer’s stock
– Balance sheet and income statement of the
combined company are generated by adding up
items

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 Accounting Method (Continued)
• Purchase method:
– Balance sheet of the combined entity is constructed as follows:
If the price paid is same as the net asset value (book value –
total liabilities), balance sheet of the combined company is
generated by adding up items
– If the price paid is less than the net asset value, the assets are
written down
– If the price paid is more than the net asset value, the assets
are appraised. If the price is still more than appraised value of
net assets, the difference is an asset called goodwill
– The income statement reflect the depreciation expenses
adjusted for the revaluation

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 Accounting for Goodwill
• The Financial Accounting Standards Board (FASB) issued
two statements changing all that:
• FASB Statement No. 141 Business Combinations
– Requires the purchase method of accounting be used for all
business combinations initiated after June 30, 2001
• FASB Statement No. 142 Goodwill and Other Intangible
Assets
– Changes the accounting for goodwill from an amortization
method to an impairment-only approach
– “Goodwill will be tested for impairment at least annually using
a two-step process that begins with an estimation of the fair
value of a reporting unit. The first step is a screen for potential
impairment, and the second step measures the amount of
impairment, if any.”
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