Fundamentals of Corporate Finance

Fourth Edition, Global Edition

Chapter 22
Mergers and
Acquisitions

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Chapter Outline
22.1 Background and Historical Trends
22.2 Market Reaction to a Takeover
22.3 Reasons to Acquire
22.4 The Takeover Process
22.5 Takeover Defenses
22.6 Who Gets the Value Added from a Takeover?

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Learning Objectives (1 of 2)
• Discuss the types of mergers and trends in merger
activity
• Understand the stock price reactions to takeover
announcements
• Critically evaluate the different reasons to acquire

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Learning Objectives (2 of 2)
• Follow the major steps in the takeover process
• Discuss the main takeover defenses
• Identify factors that determine who gets the value-
added in a merger

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22.1 Background and Historical
Trends (1 of 4)
• The Market for Corporate Control
– Acquirer (aka bidder)
– Target
• Two Primary Mechanisms
– Acquisition
– Merger

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22.1 Background and Historical
Trends (2 of 4)
• Merger Waves
– Peaks of heavy takeover activity followed by troughs of
few transactions
– Merger activity is greater during economic expansions
than contractions
– Also correlates with bull markets

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Twenty Largest Merger Transactions, August
2000 – July 2016 (1 of 3)
Table 22.1 Twenty Largest Merger Transactions, August 2000 – July 2016
Date Date Value ($
Announced Completed Target Name Acquirer Name billions)
Apr. 2007 Nov. 2007 ABN-AMRO Holding NV RFS Holdings BV 98

Mar. 2006 Dec. 2006 BellSouth Corp AT&T Inc 89

Oct. 2004 Aug. 2005 Shell Transport & Royal Dutch Petroleum 80
Trading Co Co
Feb. 2006 July 2008 Suez SA Gaz de France SA 75

Apr. 2015 Feb. 2016 BG Group PLC Royal Dutch Shell PLC 69

Nov. 2014 Mar. 2015 Allergan Inc Actavis PLC 68

Jan. 2004 Aug. 2004 Aventis SA Sanofi-Synthelabo SA 65

Jan. 2009 Oct. 2009 Wyeth Pfizer Inc 64

July 2002 Apr. 2003 Pharmacia Corp Pfizer Inc 60

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Twenty Largest Merger Transactions, August
2000 – July 2016 (2 of 3)
[Table 22.1 continued]
Date Date Value ($
Announced Completed Target Name Acquirer Name billions)
June 2008 Nov. 2008 Anheuser-Busch Cos Inc InBev NV 60

Jan. 2004 July 2004 Bank One Corp, JPMorgan Chase & Co 58
Chicago, IL
Jan. 2005 Oct. 2005 Gillette Co Procter & Gamble Co 57

May 2015 May 2016 Time Warner Cable Inc Charter 56

Communications Inc
Oct. 2003 Apr. 2004 FleetBoston Financial Bank of America Corp 49
Corp, MA
Sep. 2008 Jan. 2009 Merrill Lynch & Co Inc Bank of America Corp 48

May 2014 July 2014 DirecTV Inc AT&T Inc 48

Feb. 2004 Oct. 2004 AT&T Wireless Services Cingular Wireless LLC 47
Inc

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Twenty Largest Merger Transactions, August
2000 – July 2016 (3 of 3)
[Table 22.1 continued]
Date Date Value ($
Announced Completed Target Name Acquirer Name billions)
Dec. 2004 Aug. 2005 Nextel Communications Sprint Corp 46
Inc
Mar. 2015 July 2015 Kraft Foods Group HJ Heinz Co 46

Mar. 2009 Nov. 2009 Schering-Plough Corp Merck & Co Inc 45

Source: Thomson Financials’ SDC M&A Database.

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Figure 22.1 Percentage of Public Companies
Taken Over Each Quarter, 1926-2015
Mergers appear to occur in distinct waves, with the most recent waves
occurring in the 1980s, 1990s, and 2000s.

Source : Authors’ calculations based on Center for Research in Securities Prices data.
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22.1 Background and Historical
Trends (3 of 4)
• Types of Mergers
– Horizontal merger
 Target and acquirer are in the same industry
– Vertical merger
 Target’s industry buys or sells to acquirer’s industry
– Conglomerate merger
 Target and bidder are in different industries

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22.1 Background and Historical
Trends (4 of 4)
• Types of Mergers
– Stock Swap
– Cash Merger or Acquisition
 Payments can be very complex
– Usually some combination of forms of payment

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22.2 Market Reaction to a Takeover (1 of 2)
• Acquisition Premium
Table 22.2 Average Acquisition Premium and Stock Price
Reactions to Mergers

Premium Paid over Announcement Price Announcement Price

Premerger Price Reaction for Target Reaction for Acquirer
43% 15% 1%

Source: Data based on all U.S. deals from 1980 to 2005, as reported in Handbook of
Corporate Finance: Empirical Corporate Finance, Vol. 2, Chapter 15, pp. 291–430, B. E.
Eckbo, ed., Elsevier/North-Holland Handbook of Finance Series, 2008.

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22.2 Market Reaction to a Takeover (2 of 2)
• Three questions:
1. Why do acquirers pay a premium?
2. Why does the price of the target rise by less than the
premium?
3. If the merger is a good idea, why does the acquirer’s
price not have a large increase?

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22.3 Reasons to Acquire (1 of 7)
• Synergies
– Acquirer might be able to add economic value as a
result of the acquisition
• Economies of Scale and Scope
– Economies of scale
 Savings from producing goods in high volume
– Economies of scope
 Savings from combining the marketing and distribution of
related products

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22.3 Reasons to Acquire (2 of 7)
• Vertical Integration
– Merger of two companies in the same industry that
make products required at different stages of the
production cycle
– Principal benefit is coordination

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22.3 Reasons to Acquire (3 of 7)
• Expertise
– May be more efficient to purchase a company for its
talent pool that is already a functioning unit
• Monopoly Gains
– Antitrust laws

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22.3 Reasons to Acquire (4 of 7)
• Efficiency Gains
– Elimination of duplication
– Improvement in poor management
• Tax Savings from Operating Losses
– Can’t write off a tax loss unless you have a profit
elsewhere
– Losses in one division can be offset by profits in
another division

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Example 22.1 Taxes for a Merged
Corporation (1 of 6)
Problem:
• Consider two firms, Yin Corporation and Yang Corporation.
• Both corporations will either make $50 million or lose $20
million every year with equal probability.
• The only difference is that the firms’ profits are perfectly
negatively correlated.
• That is, any year Yang Corporation earns $50 million, Yin
Corporation loses $20 million, and vice versa. Assume that
the corporate tax rate is 34%.

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Example 22.1 Taxes for a Merged
Corporation (2 of 6)
Problem:
• What are the total expected after-tax profits of both firms
when they are two separate firms?
• What are the expected after-tax profits if the two firms are
combined into one corporation called Yin-Yang
Corporation, but are run as two independent divisions?
(Assume it is not possible to carry back or carry forward
any losses.)

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Example 22.1 Taxes for a Merged
Corporation (3 of 6)
Solution:
Plan:
• We need to calculate the after-tax profits of each firm in
both the profitable and unprofitable states by multiplying
profits by (1 − tax rate).
• We can then compute expected after-tax profits as the
weighted average of the after-tax profits in the profitable
and unprofitable states.
• If the firms are combined, their total profits in any year
would always be $50 million − $20 million = $30 million, so
the after-tax profit will always be $30 × (1 − tax rate).
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Example 22.1 Taxes for a Merged
Corporation (4 of 6)
Execute:
• Let’s start with Yin Corporation. In the profitable state,
the firm must pay corporate taxes, so after-tax profits are
$50 × (1 − 0.34) = $33 million.
• No taxes are owed when the firm reports losses, so the
after-tax profits in the unprofitable state are −$20 million.

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Example 22.1 Taxes for a Merged
Corporation (5 of 6)
Execute:
• Thus, the expected after-tax profits of Ying Corporation
are 33(0.5) + (−20)(0.5) = $6.5 million.
• Because Yang Corporation has identical expected
profits, its expected profits are also $6.5 million. Thus,
the total expected profit of both companies operated
separately is $13 million.
• The merged corporation, Yin-Yang Corporation, would
have after-tax profits of $30 × (1 − 0.34) = $19.8 million.

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Example 22.1 Taxes for a Merged
Corporation (6 of 6)
Evaluate:
• Yin-Yang Corporation has significantly higher after-tax
profits than the total stand-alone after-tax profits of Yin
Corporation and Yang Corporation.
• This is because the losses on one division reduce the
taxes on the other division’s profits.

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Example 22.1a Taxes for a Merged
Corporation (1 of 6)
Problem:
• Consider two firms, Tally Corporation and Ho Corporation.
• Both corporations will either make $100 million or lose $50
million every year with equal probability.
• The only difference is that the firms’ profits are perfectly
negatively correlated.
• That is, any year Tally Corporation earns $100 million, Ho
Corporation loses $50 million, and vice versa. Assume that
the corporate tax rate is 34%.

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Example 22.1a Taxes for a Merged
Corporation (2 of 6)
Problem:
• What are the total expected after tax profits of both firms
when they are two separate firms?
• What are the expected after-tax profits if the two firms are
combined into one corporation called Tally-Ho Corporation,
but are run as two independent divisions? (Assume it is not
possible to carry back or carry forward any losses.)

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Example 22.1a Taxes for a Merged
Corporation (3 of 6)
Solution:
Plan:
• We need to calculate the after-tax profits of each firm in
both the profitable and unprofitable states by multiplying
profits by (1 − tax rate).
• We can then compute expected after-tax profits as the
weighted average of the after-tax profits in the profitable
and unprofitable states.
• If the firms are combined, their total profits in any year
would always be $100 million − $50 million = $50 million,
so the after-tax profit will always be $50 × (1 − tax rate).

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Example 22.1a Taxes for a Merged
Corporation (4 of 6)
Execute:
• Start with Tally Corporation. In the profitable state, the
firm must pay corporate taxes, so after-tax profits are
$100 × (1 − 0.34) = $66 million.
• No taxes are owed when the firm reports losses, so the
after-tax profits in the unprofitable state are −$50 million.
• Thus, the expected after-tax profits of Tally Corporation
are 66(0.5) + (−50)(0.5) = $8.0 million.

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Example 22.1a Taxes for a Merged
Corporation (5 of 6)
Execute:
• Because Ho Corporation has identical expected profits,
its expected profits are also $8.0 million. Thus, the total
expected profit of both companies operated separately is
$16 million.
• The merged corporation, Tally-Ho Corporation, would
have after-tax profits of $50 × (1 − 0.34) = $33 million.

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Example 22.1a Taxes for a Merged
Corporation (6 of 6)
Evaluate:
• Tally-Ho Corporation has significantly higher after-tax
profits than the total stand-alone after-tax profits of Tally
Corporation and Ho Corporation.
• This is because the losses on one division reduce the
taxes on the other division’s profits.

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22.3 Reasons to Acquire (1 of 3)
• Diversification
– Risk Reduction
– Debt Capacity and Borrowing Costs
– Liquidity

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22.3 Reasons to Acquire (2 of 3)
• Earnings Growth
– It is possible that two companies combined can have
higher earnings per share than the premerger
earnings per share of either company, even if the
merger creates no economic value

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Example 22.2 Mergers and Earnings
Per Share (1 of 8)
Problem:
• Consider two corporations that both have earnings of $5
per share. The first firm, OldWorld Enterprises, is a
mature company with few growth opportunities. It has 1
million shares that are currently outstanding, priced at
$60 per share.
• The second company, NewWorld Corporation, is a
young company with much more lucrative growth
opportunities. Consequently, it has a higher value:
Although it has the same number of shares outstanding,
its stock price is $100 per share.

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Example 22.2 Mergers and Earnings
Per Share (2 of 8)
Problem:
• Assume NewWorld acquires OldWorld using its own
stock, and the takeover adds no value. In a perfect
market, what is the value of NewWorld after the
acquisition?
• At current market prices, how many shares must
NewWorld offer to OldWorld’s shareholders in exchange
for their shares?
• Finally, what are NewWorld’s earnings per share after
the acquisition?

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Example 22.2 Mergers and Earnings
Per Share (3 of 8)
Solution:
Plan:
• Because the takeover adds no value, the post-takeover
value of NewWorld is just the sum of the values of the two
separate companies: 100 × 1 million + 60 × 1 million = $160
million. To acquire OldWorld, NewWorld must pay $60
million.
• First, we need to calculate how many shares NewWorld
must issue to pay OldWorld shareholders $60 million. The
ratio of NewWorld shares issued to OldWorld Shares will
give us the exchange ratio.

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Example 22.2 Mergers and Earnings
Per Share (4 of 8)
Plan:
• Once we know how many new shares will be issued, we can
divide the total earnings of the combined company by the
new total number of shares outstanding to get the earnings
per share.

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Example 22.2 Mergers and Earnings
Per Share (5 of 8)
Execute:
• At its pre-takeover stock price of $100 per share, the deal
requires issuing 600,000 shares ($60 million/$100 =
600,000).
• As a group, OldWorld’s shareholders will then exchange 1
million shares in OldWorld for 600,000 shares in NewWorld.
• The exchange ratio is the ratio of issued shares to
exchanged shares: 600,000/1 million = 0.6.
• Therefore, each OldWorld shareholder will get 0.6 shares in
NewWorld for each 1 share in OldWorld.

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Example 22.2 Mergers and Earnings
Per Share (6 of 8)
Execute:
• Notice that the price per share of NewWorld stock is the
same after the takeover: The new value of NewWorld is
$160 million and there are 1.6 million shares outstanding,
giving it a stock price of $100 per share.
• However, NewWorld’s earnings per share have changed.
Prior to the takeover, both companies earned $5/share × 1
million shares = $5 million.

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Example 22.2 Mergers and Earnings
Per Share (7 of 8)
Execute:
• The combined corporation thus earns $10 million. There
are 1.6 million shares outstanding after the takeover, so
NewWorld’s post-takeover earnings per share are
$10million
EPS =  $6.25 / share
1.6millionshares

• By taking over OldWorld, NewWorld has raised its

earnings per share by $1.25.

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Example 22.2 Mergers and Earnings
Per Share (8 of 8)
Evaluate:
• Because no value was created, we can think of the
combined company as simply a portfolio of NewWorld and
OldWorld.
• Although the portfolio has higher total earnings per share,
it also has lower growth because we have combined the
low-growth OldWorld with the high-growth NewWorld.
• The higher current earnings per share has come at a price
—lower earnings per share growth.

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Example 22.2a Mergers and Earnings
Per Share (1 of 8)
Problem:
• Consider two corporations that both have earnings of $8
per share. The first firm, Beenaround, is a mature
company with few growth opportunities. It has 2 million
shares that are currently outstanding, priced at $50 per
share.
• The second company, Movenin Corporation, is a young
company with much more lucrative growth opportunities.
Consequently, it has a higher value: Although it has the
same number of shares outstanding, its stock price is
$80 per share.

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Example 22.2a Mergers and Earnings
Per Share (2 of 8)
Problem:
• Assume Movenin acquires Beenaround using its own
stock, and the takeover adds no value. In a perfect
market, what is the value of Movenin after the
acquisition?
• At current market prices, how many shares must
Movenin offer to Beenaround’s shareholders in
exchange for their shares?
• Finally, what are Moveznin’s earnings per share after the
acquisition?

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Example 22.2a Mergers and Earnings
Per Share (3 of 8)
Solution:
Plan:
• Because the takeover adds no value, the post-takeover
value of Movenin is just the sum of the values of the two
separate companies: 50 × 2 million + 80 × 2 million = $260
million.
• To acquire Beenaround, Movenin must pay $100 million. We
need to first calculate how many shares Movenin must issue
to pay Beenaround shareholders $100 million.
• The ratio of Movenin shares issued to Beenaround shares
will give us the exchange ratio.
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Example 22.2a Mergers and Earnings
Per Share (4 of 8)
Plan:
• Once we know how many new shares will be issued, we can
divide the total earnings of the combined company by the
new total number of shares outstanding to get the earnings
per share.

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Example 22.2a Mergers and Earnings
Per Share (5 of 8)
Execute:
• At its pre-takeover stock price of $80 per share, the deal
requires issuing 1,250,000 shares ($100 million / $80 =
1,250,000).
• As a group, Beenaround’s shareholders will then exchange 2
million shares in Beenaround for 1,250,000 shares in Movenin.
• The exchange ratio is the ratio of issued shares to exchanged
shares: 1,250,000/2 million = 0.625.
• Therefore, each Beenaround shareholder will get 0.625 share
in Movenin for each 1 share in Beenaround.

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Example 22.2a Mergers and Earnings
Per Share (6 of 8)
Execute:
• Notice that the price per share of Movenin stock is the same
after the takeover: The new value of Movenin is $260 million
and there are 3.25 million shares outstanding, giving it a stock
price of $80 per share.
• However, Movenin’s earnings per share have changed. Prior to
the takeover, both companies earned $8/share × 2 million
shares = $16 million.
• The combined corporation thus earns $32 million.

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Example 22.2a Mergers and Earnings
Per Share (7 of 8)
Execute:
• There are 3.25 million shares outstanding after the
takeover, so Movenin’s post-takeover earnings per share
are
$32million
EPS =  $9.85 / share
3.25millionshares

• By taking over Beenaround, Movenin has raised its

earnings per share by $1.85.

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Example 22.2a Mergers and Earnings
Per Share (8 of 8)
Evaluate:
• Because no value was created, we can think of the
combined company as simply a portfolio of Movenin and
Beenaround.
• Although the portfolio has higher total earnings per share,
it also has lower growth because we have combined the
low-growth Beenaround with the high-growth Movenin.
• The higher current earnings per share has come at a price
—lower earnings per share growth.

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Example 22.3 Mergers and the Price-
Earnings Ratio (1 of 4)
Problem:
• Calculate NewWorld’s price-earnings ratio, before and
after the takeover described in Example 22.2.

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Example 22.3 Mergers and the Price-
Earnings Ratio (2 of 4)
Solution:
Plan:
• The price-earnings ratio is price per share / earnings per
share. NewWorld’s price per share is $100 both before
and after the takeover, and its earnings per share is $5
before and $6.25 after the takeover.

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Example 22.3 Mergers and the Price-
Earnings Ratio (3 of 4)
Execute:
• Before the takeover, NewWorld’s price-earnings ratio is

$100 / share
P/E   20
$5 / share

• After the takeover, NewWorld’s price-earnings ratio is

$100 / share
P/E   16
$6.25 / share

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Example 22.3 Mergers and the Price-
Earnings Ratio (4 of 4)
Evaluate:
• The price-earnings ratio has dropped to reflect the fact
that after taking over OldWorld, more of the value of
NewWorld comes from earnings from current projects than
from its future growth potential.

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Example 22.3a Mergers and the Price-
Earnings Ratio (1 of 4)
Problem:
• Calculate Movenin’s price-earnings ratio, before and after
the takeover described in Example 22.2a.

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Example 22.3a Mergers and the Price-
Earnings Ratio (2 of 4)
Solution:
Plan:
• The price-earnings ratio is price per share / earnings per
share. Movenin’s price per share is $80 both before and
after the takeover, and its earnings per share is $8 before
and $9.85 after the takeover.

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Example 22.3a Mergers and the Price-
Earnings Ratio (3 of 4)
Execute:
• Before the takeover, Movenin’s price-earnings ratio is:

$80 / share
P/E   10
$8 / share

• After the takeover, Movenin’s price-earnings ratio is:

$80 / share
P /E   8.12
$9.85 / share

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Example 22.3a Mergers and the Price-
Earnings Ratio (4 of 4)
Evaluate:
• The price-earnings ratio has dropped to reflect the fact
that after taking over Beenaround, more of the value of
Movenin comes from earnings from current projects than
from its future growth potential.

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22.3 Reasons to Acquire (3 of 3)
• Managerial motives to merge
– Conflicts of Interest
– Overconfidence

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22.4 The Takeover Process (1 of 12)
• Valuation
– Compare the Target to Similar Firms
 Rough estimate
 Does not incorporate synergies
– Discounted Cash Flows
 Harder to implement, but does include synergies

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22.4 The Takeover Process (2 of 12)
• The Offer
– Public Announcement
 Cash Transaction
 Stock Swap
– Exchange ratio
– Positive NPV transaction if share price of merged firm
exceeds premerger acquirer price

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22.4 The Takeover Process (3 of 12)
• Stock swap is positive NPV if:
A T  S A
 (Eq. 22.1)
NA  x NA

– Where:
 A = premerger value of acquirer
 T = premerger value of target
 S = value of synergies
 NA = shares outstanding of acquirer premerger
 x = number of shares issued in the merger

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22.4 The Takeover Process (4 of 12)
• Re-writing equation 22.1 to solve for the maximum
value of x that will still give a positive NPV:

T  S  (Eq. 22.2)
x  NA
 A 

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22.4 The Takeover Process (5 of 12)
• We can express this as an exchange ratio by
dividing both sides by the premerger number of
target shares (NT):

x  T  S  NA
ExchangeRatio    (Eq. 22.3)
NT  A  NT

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22.4 The Takeover Process (6 of 12)
• Rewrite Equation 22.3 in terms of premerger
target and acquirer share prices
T T
PT  and PA  :
NT NA

PT  S 
Exchange Ratio  1   (Eq. 22.4)
PA  T 

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Example 22.4 Maximum Exchange
Ratio in a Stock Takeover (1 of 4)
Problem:
• At the time Sprint announced plans to acquire Nextel in
December 2004, Sprint stock was trading for $25 per
share and Nextel stock was trading for $30 per share.
• If the projected synergies were $12 billion, and Nextel
had 1.033 billion shares outstanding, what is the
maximum exchange ratio Sprint could offer in a stock
swap and still generate a positive NPV?
• What is the maximum cash offer Sprint could make?

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Example 22.4 Maximum Exchange
Ratio in a Stock Takeover (2 of 4)
Solution:
Plan:
• We can use Equation 22.4 to compute the maximum
shares Sprint could offer and still have a positive NPV.
To compute the maximum cash offer, we can calculate
the synergies per share and add that to Nextel’s current
share price.

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Example 22.4 Maximum Exchange
Ratio in a Stock Takeover (3 of 4)
Execute:
• Using Equation 22.4,
PT  S  30  12 
Exchange Ratio   1    1    1.665
PA  T  25  31 

• That is, Sprint could offer up to 1.665 shares of Sprint

stock for each share of Nextel stock and generate a
positive NPV.
• For a cash offer, given synergies of $12 billion/1.033 billion
shares = $11.62 per share, Sprint could offer up to $30 +
11.62 = $41.62.
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Example 22.4 Maximum Exchange
Ratio in a Stock Takeover (4 of 4)
Evaluate:
• Both the cash amount and the exchange offer 1$25 ×
1.665 = $41.622 have the same value.
• That value is the most that Nextel is worth to Sprint—if
Sprint pays $41.62 for Nextel, it is paying full price plus
paying Nextel shareholders for all the synergy gains
created—leaving none for Sprint shareholders.
• Thus, at $41.62, buying Nextel is exactly a zero-NPV
project.

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Example 22.4a Maximum Exchange
Ratio in a Stock Takeover (1 of 4)
Problem:
• At the time America Online (AOL) announced plans to
acquire Time Warner in January 2000, AOL stock was
trading for $73.76 per share and Time Warner stock was
trading for $65.69 per share.
• If the projected synergies were $40 billion, and Time
Warner had 2.2 billion shares outstanding, what is the
maximum exchange ratio AOL could offer in a stock
swap and still generate a positive NPV?
• What is the maximum cash offer AOL could make?

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Example 22.4a Maximum Exchange
Ratio in a Stock Takeover (2 of 4)
Solution:
Plan:
• We can use Equation 22.4 to compute the maximum
shares AOL could offer and still have a positive NPV. To
compute the maximum cash offer, we can calculate the
synergies per share and add that to Time Warner’s
current share price.

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Example 22.4a Maximum Exchange
Ratio in a Stock Takeover (3 of 4)
Execute:
• Using Equation 22.4,
PT  S  65.69  40 
Exchange Ratio   1     1    1.137
PA  T  73.76  144.5 

• That is, AOL could offer up to 1.137 shares of AOL stock

for each share of Time Warner stock and generate a
positive NPV.
• For a cash offer, given synergies of $40 billion/2.2 billion
shares = $18.18 per share. Thus, AOL could offer up to
$65.69 + $18.18 = $83.87 per share.
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Example 22.4a Maximum Exchange
Ratio in a Stock Takeover (4 of 4)
Evaluate:
• Both the cash amount and the exchange offer ($73.76 ×
1.137 = $83.87) have the same value.
• That value is the most that Time Warner is worth to AOL
– If AOL pays $83.87 for Time Warner, it is paying full price
plus paying Time Warner shareholders for all the synergy
gains created, leaving none for AOL shareholders.
• Thus, at $83.87, buying Time Warner is exactly a zero-
NPV project.

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22.4 The Takeover Process (7 of 12)
• Merger “Arbitrage"
– Risk Arbitrageurs
 Traders who, once a takeover offer is announced,
speculate on the outcome of the deal
 Given the uncertainty about a takeover’s success, the
market price does not rise by the amount of the
premium upon announcement
– Merger-Arbitrage Spread
 Difference between target’s stock price and implied
offer price.
 Not truly arbitrage

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Figure 22.2 Merger-Arbitrage Spread for
the Merger of HP and Compaq

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22.4 The Takeover Process (8 of 12)
• Tax and Accounting Issues
– Form of payment affects taxes of target shareholders
and combined firm
– Cash received triggers immediate tax liability
– Stock swap defers taxes until shares are sold

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22.4 The Takeover Process (9 of 12)
• Tax and Accounting Issues
– Step Up
 An increase in the book value of a target’s assets to
the purchase price when an acquirer purchases those
assets directly instead of purchasing the target stock
 Higher depreciable basis reduces future taxes
 Goodwill can be amortized

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22.4 The Takeover Process (10 of 12)
• Board and Shareholder Approval
– Friendly Takeover
– Hostile Takeover
 Corporate Raider

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22.4 The Takeover Process (11 of 12)
• Board and Shareholder Approval
– Board may not approve even if a premium is offered
 Might think offer price is too low
 In a stock swap, might think acquirer is overvalued
 Might be self interest (agency problem)
– Many times entire management team is changed

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22.4 The Takeover Process (12 of 12)
• Board and Shareholder Approval
– In theory, target board’s duty is to act in the best
interest of target shareholders.
 Revlon Duties
– Must seek the highest value
 Unocal
– When board takes defensive actions those actions are
subject to extra scrutiny
– Defenses must not be coercive or designed to preclude
a deal

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22.5 Takeover Defenses (1 of 6)
• Proxy Fight
– Acquirer attempts to convince target shareholders to
use proxy votes to support acquirers’ candidates for
election to the target board
• Several strategies to stop this process:
– Can force a bidder to raise the bid
– Can entrench management more securely

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22.5 Takeover Defenses (2 of 6)
• Poison Pills
– Rights offering that gives existing target shareholders
the right to buy shares in the target at a deeply
discounted price under certain conditions
– Makes it more difficult to replace bad managers
 Firm’s stock price drops when poison pill is adopted
 Firms with poison pills have below average financial
performance

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22.5 Takeover Defenses (3 of 6)
• Staggered Boards
– Board of directors’ terms are staggered so that only
one-third of the directors are up for election each
year
• White Knights
– Target looks for a friendlier company to acquire it
• White Squire
– A large, passive investor or firm agrees to purchase
a substantial block of shares in a target with special
voting rights

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22.5 Takeover Defenses (4 of 6)
• Golden Parachutes
– Lucrative severance package guaranteed to senior
managers in the event that the firm is taken over and
the managers are let go
– Empirical evidence suggests that it is value-
increasing because management is more likely to be
receptive to a takeover

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22.5 Takeover Defenses (5 of 6)
• Recapitalization
– Company changes capital structure to make itself
less attractive
 For example, pay out large dividend

• Other Defensive Strategies

– Supermajority
– Restricted voting rights for large shareholders
– “Fair” price

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22.5 Takeover Defenses (6 of 6)
• Regulatory Approval
– Sherman Act
– Clayton Act
– Hart-Scott-Rodino Act

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22.6 Who Gets the Value Added from a
Takeover? (1 of 8)
• The Free Rider Problem
– Assume HighLife Corporation has 1 million
shareholders, each holding 1 share
– The management is not doing a good job, so the
shares trade at a deep discount
 They currently trade at $45 per share
 With good management they could be worth $75 each

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22.6 Who Gets the Value Added from a
Takeover? (2 of 8)
• The Free Rider Problem
– A simple majority is required to make all decisions,
so control can be bought with 50% of outstanding
shares
– T. Boone Icon wants to fix the situation by making a
tender offer at $60 per share
 If 50% of shareholders tender, T. Boone makes a large
profit ($15 per share when performance improves)

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22.6 Who Gets the Value Added from a
Takeover? (3 of 8)
• The Free Rider Problem
– The offer price exceeds the current price, so tendering
shareholders make a profit ($60 − $45 = $15 per
share)
– However, if the offer succeeds, remaining shareholders
make a higher profit ($75 − $45 = $30 per share) by
allowing the other shareholders to tender

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22.6 Who Gets the Value Added from a
Takeover? (4 of 8)
• The Free Rider Problem
– All shareholders know this, so the offer will not be
successful
– The only way enough shareholders will tender is for T.
Boone to offer at least $75 per share
 The raider gives up his profit
 Existing shareholders do not have to invest time and
effort, hence the term “free rider”

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22.6 Who Gets the Value Added from a
Takeover? (5 of 8)
• Toeholds
– An initial ownership stake in a firm that a corporate
raider can use to initiate a takeover attempt
– T. Boone can acquire up to about 10% of the firm in
secret
 He can then buy another 40% for $75 per share and
realize a profit from his initial 10%
– Corporate raiders perform an important service
because management knows they exist

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22.6 Who Gets the Value Added from a
Takeover? (6 of 8)
• The Leveraged Buyout
– Another lower-cost mechanism for corporate raiders
– T. Boone announces a tender offer for half the
outstanding shares at $50 per share.
 Instead of using his own cash, he borrows money
through a shell corporation with the shares as collateral
 If the tender offer succeeds, T. Boone can merge the
target with the shell corporation and debt is owed by the
target
 Shareholders will tender because the outstanding debt
makes the share price $50 after the takeover

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Example 22.5 Leveraged Buyout (1 of 8)
Problem:
• FAT Corporation stock is currently trading at $40 per share.
There are 20 million shares outstanding, and the company
has no debt.
• You are a partner in a firm that specializes in leveraged
buyouts. Your analysis indicates that the management of
this corporation could be improved considerably.
• If the managers were replaced with more capable ones,
you estimate that the value of the company would increase
by 50%.

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Example 22.5 Leveraged Buyout (2 of 8)
Problem:
• You decide to initiate a leveraged buyout and issue a
tender offer for at least a controlling interest—50% of the
outstanding shares.
• What is the maximum amount of value you can extract and
still complete the deal?

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Example 22.5 Leveraged Buyout (3 of 8)
Solution:
Plan:
• Currently, the value of the company is $40 × 20 million =
$800 million, and you estimate you can add an additional
50%, or $400 million.
• If you borrow $400 million and the tender offer succeeds,
you will take control of the company and install new
management.
• The total value of the company will increase by 50% to $1.2
billion. You will also attach the debt to the company, so the
company will now have $400 million in debt.
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Example 22.5 Leveraged Buyout (4 of 8)
Plan:
• You can then compute the value of the post-takeover equity
and your gain.
• You can repeat this computation assuming you borrow
more than $400 million and confirming that your gain does
not change.

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Example 22.5 Leveraged Buyout (5 of 8)
Execute:
• The value of the equity once the deal is done is the total
value minus the debt outstanding:
Total Equity = $1200 million − $400 million = $800 million
• The value of the equity is the same as the premerger value.
• You own half the shares, which are worth $400 million, and
paid nothing for them, so you have captured the value you
anticipated adding to FAT.

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Example 22.5 Leveraged Buyout (6 of 8)
Execute:
• What if you borrowed more than $400 million? Assume you
were able to borrow $450 million. The value of equity after
the merger would be
Total Equity = $1200 million − $450 million = $750 million
• This is lower than the premerger value. Recall, however,
that in the United States, existing shareholders must be
offered at least the premerger price for their shares.
• Because existing shareholders anticipate that the share
price will be lower once the deal is complete, all
shareholders will tender their shares.
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Example 22.5 Leveraged Buyout (7 of 8)
Execute:
• This implies that you will have to pay $800 million for these
shares, and so to complete the deal, you will have to pay
$800 million − $450 million = $350 million out of your own
pocket. In the end, you will own all the equity, which is
worth $750 million.
• You paid $350 million for it, so your profit is again $400
million.

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Example 22.5 Leveraged Buyout (8 of 8)
Evaluate
• In each case, the most you can gain is the $400 million in
value you add by taking over FAT.
• Thus, you cannot extract more value than the value you
add to the company by taking it over.

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Example 22.5a Leveraged Buyout (1 of 5)
Problem:
• Lazy Corporation stock is currently trading at $50 per
share. There are 10 million shares outstanding, and the
company has no debt.
• You are a partner in a firm that specializes in leveraged
buyouts. Your analysis indicates that the management of
this corporation could be improved considerably.
• If the managers were replaced with more capable ones,
you estimate that the value of the company would increase
by 60%.

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Example 22.5a Leveraged Buyout (2 of 5)
Problem:
• You decide to initiate a leveraged buyout and issue a
tender offer for at least a controlling interest—50% of the
outstanding shares.
• What is the maximum amount of value you can extract and
still complete the deal?

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Example 22.5a Leveraged Buyout (3 of 5)
Solution:
Plan:
• Currently, the value of the company is $50 × 10 million =
$500 million and you estimate you can add an additional
60%, or $300 million.
• If you borrow $250 million and the tender offer succeeds,
you will take control of the company and install new
management.
• The total value of the company will increase by 60% to
$800 million. You will also attach the debt to the company,
so the company will now have $250 million in debt.
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Example 22.5a Leveraged Buyout (4 of 5)
Plan:
• You can then compute the value of the post-takeover equity
and your gain.
• You can repeat this computation assuming you borrow
more than $250 million and confirming that your gain does
not change.

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Example 22.5a Leveraged Buyout (5 of 5)
Execute:
• The value of the equity once the deal is done is the total
value minus the debt outstanding:
Total Equity = $800 million − $250 million = $550 million
• The value of the equity is more than the premerger value.
• You own half the shares, which are worth $275 million, and
paid nothing for them, so you have captured the value you
anticipated adding to Lazy.

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22.6 Who Gets the Value Added from a
Takeover? (7 of 8)
• The Freezout Merger
– Used by companies acquiring other companies
 Leveraged buyout is used by groups of investors
– Acquiring company makes a tender offer at a slight
premium
 If offer succeeds, acquirer gains control and merges into
a new corporation
 Non-tendering shareholders get the right to receive the
tender offer price

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22.6 Who Gets the Value Added from a
Takeover? (8 of 8)
• Competition
– Competition in the takeover market means that most of
the benefit to the merger goes to target shareholders
 If the premium is not high enough, another company will
submit a higher bid

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Chapter Quiz (1 of 3)
1. What are merger waves?
2. What is the difference between a horizontal and a
vertical merger?
3. On average, what happens to the target share price
on the announcement of a takeover?
4. On average, what happens to the acquirer share
price on the announcement of a takeover?

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Chapter Quiz (2 of 3)
5. Explain why risk diversification benefits and
earnings growth are not good justifications for a
takeover intended to increase shareholder wealth.
6. What are the steps in the takeover process?
7. What do risk arbitrageurs do?
8. What defensive strategies are available to help
target companies resist an unwanted takeover?
9. How can a hostile acquirer get around a poison pill?

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Chapter Quiz (3 of 3)
10. What mechanisms allow corporate raiders to get
around the free rider problem in takeovers?
11. Based on the empirical evidence, who gets the
value added from a takeover? What is the most
likely explanation of this fact?

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