Corporate Finance

Week 9
MERGERS AND ACQUISITIONS

Mohsin Khawaja
Basic Definitions
 Merger: Complete absorption of one company by
another wherein the acquiring firm retains its
identity and the acquired firm ceases to exist as
a separate entity
 Statutory merger
 Subsidiary merger
 Consolidation
 Acquisition: Purchase of firm’s voting stock with
an exchange of cash or shares
 Takeover: Attempt to acquire a company against
the wishes of its managers and board of
directors
Takeovers
Types of Mergers
 Horizontal merger takes place between two
firms in the same line of business
 Vertical merger involves companies at

different stages of production

 Conglomerate merger involves companies in

unrelated lines of businesses

Merger process
 Friendly mergers
◦ Acquirer approaches the target’s management.
◦ Companies enter into merger discussion (post-merger
management structure, etc)
◦ Due diligence-each party examines other’s books and records.
◦ Terms of transaction are negotiated and firms enter into
merger agreement
◦ Management endorses the merger and recommends that the
shareholders approve the transaction
 Hostile mergers
◦ Acquirer may circumvent target's management and directly
submit merger proposal to board of directors
◦ Target’s management can undertake defense mechanism to
resist the takeover
Antitakeover measures
 Golden parachutes
◦ Large termination arrangements made for executives that are activated
after a takeover
 Poison pills
◦ Dilution of the value of shares acquired by a hostile bidder through the
offer of additional shares to all other existing shareholders at a
discounted price
 Poison puts
◦ Put options in bonds allowing holders to sell bonds back to the
company at prespecified price in the event of a hostile takeover
 White knight defense
◦ Pursuit of a friendly acquirer to take over the company instead of the
hostile acquirer
 Supermajority approvals
◦ Corporate charter amendments that require the approval of large
majority for a takeover to occur
Accounting for mergers
 Fair price of firm B’s fixed assets = $14
 Firm A pays $18 through debt issuance
 What is the value of goodwill?
 Construct the post-merger balance sheet?
Accounting for mergers
 Goodwill = Amount paid – (market value of
assets – market value of liabilities)
 Goodwill (AB) = 18 – (14 + 2) = $2
 Post-merger balance sheet:
Accounting for mergers
 Fair value of Essex’ fixed assets = $9,300
 Amherst pays $16,000 through debt issuance
Sensible Motives for Mergers
 Achieve synergies to reduce cost and enhance
revenue
 Vertical integration facilitates coordination

and administration
 Achieve growth and increase market power
 Acquire specific competencies/resources

which a company lacks

 Alternative to a good investment for a firm

with surplus cash

 Simple solution to eliminate inefficiencies
Dubious Motives for Mergers
 Corporate executives might engage in mergers to
maximize the size of their company rather than
shareholder value
 Mergers help achieve corporate diversification, but
diversification is easier and cheaper for shareholders
 Mergers lower financing cost, allow increased
borrowing and higher interest tax shields, but with
existing debts of merging firms stockholders tend to
lose
 Mergers can increase earnings per share, though
there is no increase in the two firms’ combined value
and no real gain created-the bootstrap game
Example 1: Bootstrapping
Bootstrapping: Short-term boost in the earnings of acquirer
even though there is no economic benefit

World Enterprises Muck and World Enterprises

before Merger Slurry after Merger

Earnings per share $2.00 $2.00 $2.67

Price per share $40 $20 $40

Price-earnings ratio 20 10 15

Number of shares 100,000 100,000 150,000

Total earnings $200,000 $200,000 $400,000

Total market value $4,000,000 $2,000,000 $6,000,000

Example 2: Bootstrapping
 Firm A acquires B by issuing 25 shares
 Market value of post-merger firm = $11,000
 What is post-merger EPS & P/E?
Benefit from Merger
 A successful merger requires that the value of the
whole exceed the sum of the parts:

 Incremental gain from acquisition is:

 When is positive, the acquisition is said to generate

synergy
 Acquirer’s gains are derived from the synergies
generated by the transaction, usually some
combination of cost reduction or revenue
enhancement. Value of target for the acquirer is:
Example 3
Firms A and B are competitors with very similar
assets and business risks. Both are all-equity
firms with after-tax cash flows of $10 per year
forever, and both have an overall cost of capital
of 10 percent. Firm A is thinking of buying
Firm B. the after-tax cash flow from the
merged firm would be $21 per year. Does the
merger generate synergy? What is the total
value of firm B to firm A? What is the change in
value?
Merger Analysis
 Cost of mergers
◦ Cash, Stock or Mixed Offering

 Target Company Valuation

◦ Discounted Cash Flow Analysis
◦ Comparable Company Analysis
◦ Comparable Transaction Analysis
Cost of mergers
 Cash offering: cash might come from
acquiring company’s existing assets or from
debt issue
 Securities offering: target shareholders get

acquirer’s common shares as compensation.

Exchange ratio determines the number of
acquirer’s shares received in exchange of
target’s shares
 Mixed offering: combination of cash and

stocks
Cash offering - example
 Incremental value of acquisition = $100
 Sale price of firm B = $150

1. What is the NPV of cash acquisition?

2. What is the value of post-merger firm?
3. What is the post-merger share price?
Cash offering - solution
 Value of firm B:
 = 100 + 100
 = $200

 NPV = - Cost of acquisition

 NPV = 200 – 150 = $50

 = + (- Cost)
 = 500 + (200 – 150) = $550

 Share price = $550/25 = $22

Stock offering - example
 Incremental value of acquisition = $100
 Sale price of firm B = $150

1. In a stock offering, what is the NPV of the

acquisition?
2. Compute the post-merger share price.
Stock offering - solution
 = + (- Cost)
 = 500 + 200 – 0 = 700

Cost of acquisition = (#shares) x (price/share)

 Firm A shares required = 150/20 = 7.5
 Total shares = 25 + 7.5 = 32.5
 New share price = 700/32.5 = $21.54
 Cost = 7.5 x 21.54 = $161.55

 NPV = - Cost
 NPV = 200 – (161.55) = $38.45
Example 3
Discount Books, a Canadian bookseller, has announced its intended
acquisition of Premier Marketing Corporation, a small marketing
company specializing in print media. In a press release, Discount
Books outlines the terms of the merger, which specify that Premier
Marketing’s shareholders will each receive 0.90 shares of Discount
Book for every share of Premier Marketing owned. Premier Marketing
has 1 million shares outstanding. On the day of merger
announcement, Discount Book’s stock closed at c$20.00 and Premier
Marketing’s stock closed at C$15.00. Catherine Willis is an individual
investor who owns 500 shares of Premier Marketing, currently worth
C$7,500.
a. Based on the current stock prices, what is the cost of the
acquisition for Discount Books?
b. How many shares of Discount Books will Catherine receive, and
what is the value of those shares (based on current share prices)?
Which Payment Method to use?
 If acquiring company’s management is
confident about the value to be created by
merger, cash offering is preferred
 If acquirer’s shares are overvalued, security

offering is preferred
 Payment method used depends on the

desired capital structure after merger

Bid Evaluation
 The acquirer will want to pay the lowest possible
price which is the pre-merger value of target
 The target will negotiate for the highest possible
bid which is the sum of pre-merger value of
target plus the value of any expected synergies
 Each side of transaction negotiates to capture as
much of the synergies as possible
 Price and form of payment in merger determines
the distribution of benefits to the counterparties
Discounted Cash Flow Analysis
 Target’s free cash flows (FCFs) are estimated
for an appropriate time horizon
 Terminal value of target is estimated at the

end of the first stage period

◦ Cash flows in second stage period can be assumed
to grow at constant growth rate
◦ Multiple can be applied at which the target is
expected to sell at the end of first stage period
 FCFs in the first stage period and terminal
value are discounted and added to get the
target’s intrinsic value
Comparable Company Analysis
 A set of companies similar to target company
is defined
◦ Companies from same or other industries
◦ Same size, same capital structure
 Various relative value measures (PE, PB, PS,
etc) based on current market price of
comparable companies are calculated
 Mean value of the above relative measures

are applied to the corresponding estimates

for the target to develop an estimated
company value
Takeover Premium
 Takeover premium is estimated and added to the
target company’s value determined using stand-
alone DCF or comparable companies approach
 It is the amount by which the takeover price for
each share must exceed the current stock price
 It is usually expressed as a percentage of the
stock price and estimated as:

 It is calculated by compiling a list of takeover

premiums paid for companies similar to the
target in the recent past
Comparable Transaction Analysis
 A sample of recent takeover transactions is
identified
 Various relative value measures (PE, PB, etc)

based on actual price paid for other merger

deals are calculated
 Mean value of the above relative measures

are applied to the corresponding estimates

for the target to develop an estimated
takeover value
Do mergers benefit the
shareholders?
 Short term performance studies examine stock
returns of acquirer and target firms surrounding
merger announcement dates. Target shareholders
reap huge premiums whereas findings for bidders
are mixed (Weston & Weaver, 2001)
 Long term performance studies track the
performance of post merger companies. Evidence
shows that acquirers tend to underperform
comparable companies during three years
following an acquisition (Koller, Goedhart &
Wessels, 2005)
References
 Brealey, R. A, Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles
of Corporate Finance. India: McGraw Hill
 Corporate Finance. CFA Level II Program Curriculum
 Koller, T., Goedhart, M., & Wessels, D. (2005). Valuation: Measuring
and Managing the Value of Companies. Hoboken, NJ: John Wiley &
Sons
 Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2012). Fundamentals
of Corporate Finance. India: McGraw Hill
 Weston, J. F., & Weaver, S. C. (2001). Mergers & Acquisitions. New
York: McGraw Hill