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Principles of Corporate Finance, 14th

Edition
Chapter 32: Mergers

Brealey, Myers, Allen, and Edmans

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Topics Covered
• Types of Mergers.
• Sensible Motives for Mergers.
• Some Dubious Reasons for Mergers.
• Estimating Merger Gains and Costs.
• The Mechanics of a Merger.
• Takeovers and the Market for Corporate Control.
• Merger Waves and Merger Profitability.

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 Types of Mergers
Horizontal Merger.
• One that 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 business.

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 Table 32.1 Some Important Merger
Announcements in 2020
Payment
Industry Acquiring Company Selling Company ($ billions)
Media AT&T Time Warner 109
Pharmaceuticals Bristol-Myers Squibb Celgene 90
Defense United Technologies Raytheon 89
Pharmaceuticals AbbVie Allergan 86
Media Disney 21st Century Fox 71
Energy/petrochemicals Saudi Aramco (Saudi) Saudi Basic Industries (Saudi) 70
Banking BB&T Corp SunTrust 66

Pharmaceuticals Takeda Pharmaceuticals Shire (UK) 59

(Japan)
Energy Occidental Anadarko 54
Autos Fiat Chrysler PSA - Peugeot (France) 50
Financial technology FI S Worldpay 35
Computing IBM Red Hat 34

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 Sensible Motives for Mergers 1

Economies of Scale.
• A larger firm may be able to reduce its per-unit cost by
using excess capacity or spreading fixed costs across
more units.
Economies of Vertical Integration.
• Control over suppliers “may” reduce costs.
• Overintegration can cause the opposite effect.
Complementary Resources.
• Merging may result in each firm filling in the “missing
pieces” of its firm with pieces from the other firm.

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 Sensible Motives for Mergers 2

Surplus Funds.
• If your firm is in a mature industry with few, if any, positive-
NPV projects available, acquisition may be the best use of
your funds.
Changes in Corporate Control.
• Poor management may waste money, make poor decisions,
conduct improper risk/return investments, and harm the
value of the company.
• Sometimes, the only way to remedy the situation is to
change management.

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 Sensible Motives for Mergers 3

Industry Consolidation.
• The biggest opportunities to improve efficiency seem to
come in industries with too many firms and too much
capacity.
• These conditions often trigger a wave of mergers and
acquisitions, which then force companies to cut capacity
and employment and release capital for reinvestment
elsewhere in the economy.

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 Some Dubious Reasons for Mergers
Diversification.
• Diversification is easier and cheaper for the stockholder
than for the corporation. There is little evidence that
investors pay a premium for diversified firms.
Increasing Earnings per Share: The Bootstrap Game.
• Acquiring firm has high P/E ratio.
• Selling firm has low P/E ratio (due to low number of
shares).
• After merger, acquiring firm has short-term EPS rise.
• Long term, acquirer will have slower than normal EPS
growth due to share dilution.
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 Table 32.2 Impact of Merger on Market Value and
Earnings Per Share of World Enterprises
World Enterprises Muck and World Enterprises
before Merger Slurry after Merger
1. Earnings per share $2.00 $2.00 $2.67
2. Price per share $40 $20 $40
3. Price–earnings ratio 20 10 15
4. Number of shares 100,000 100,000 150,000
5. Total earnings $200,000 $200,000 $400,000
6. Total market value $4,000,000 $2,000,000 $6,000,000
7. Current earnings per $0.05 $0.10 $0.067
dollar invested in stock
(line 1 ÷ line 2)

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 Figure 32.1 Effects of Merger on Earnings
Growth

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 Estimating Merger Gains and Costs 1

Questions
• Is there an overall economic gain to the merger?
• Do the terms of the merger make the company and its
shareholders better off?

PV(AB)  PV(A)  PV(B)

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 Estimating Merger Gains and Costs 2

Gain  PVAB  (PVA  PVB )  PVAB

Cost  cash paid  PVB
NPV = gain  cost
 PVAB   cash  PVB 

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 Estimating Merger Gains and Costs 3

Example: Two firms merge, creating $25 million in

synergies. If A buys B for $65 million, the cost is $15 million.

PVA  $200
PVB  $50
Gain  PVAB  $25
PVAB  $275 million

Cost  cash paid  PVB

 65  50  $15 million

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 Estimating Merger Gains and Costs 4

Example: The NPV to A will be the difference between the

gain and the cost.

NPVA  $25  $15  $10 million

NPVA  wealth with merger  wealth without merger

  PVAB  cash   PVA
 $275  $65   $200
 $10 million

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 Right and Wrong Ways to Estimate the Benefits
of Mergers

Estimated net gain = DCF valuation of target, including

merger benefits − cash required for
acquisition.
• Ask why the two firms should be worth more together than
apart.
• You add value only if you can generate additional
economic rents.

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 Table 32.3 Accounting for the Merger
Balance Sheet of A Corporation Balance Sheet of B Corporation
NW C 20 30 D NW C 1 0 D
FA 80 70 E FA 9 10 E
Blank Blank Blank Blank

100 100 10 10

Balance Sheet of AB Corporation

NW C 21 30 D
FA 89 88 E
Blank Blank

Goodwill 8
Blank Blank

118 118

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 Table 32.4 Possible Tax Consequences

Taxable Merger Tax-Free Merger

Impact on Captain B must recognize a Capital gain can be deferred
Captain B $30,000 capital gain. until Captain B sells the
Baycorp shares.
Impact on Boat is revalued at $280,000. Boat’s value remains at
Baycorp Tax depreciation increases to $150,000, and tax
$280,000/10 = $28,000 per year depreciation continues at
(assuming 10 years of remaining $15,000 per year.
life).

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 Takeovers and the Market for Corporate Control

Proxy Contests.
• A proxy is the right to vote another shareholder’s shares.
• Dissident shareholders attempt to obtain enough proxies to
elect their own slate to the BOD.
Takeovers.
• Tender offer of cash directly to the shareholders.
• Exchange offer of stock (and cash) directly to the
shareholders.
• If successful, new owner is free to make any management
changes.

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 Takeover Defenses
White knight: Friendly potential acquirer sought by a target
company threatened by an unwelcome suitor.
Shark repellent: Amendments to a company charter made
to forestall takeover attempts.
Poison pill: Measure taken by a target firm to avoid
acquisition; for example, the right for existing shareholders to
buy additional shares at an attractive price if a bidder
acquires a large holding.

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 Table 32.5 A Summary of Takeover Defenses
Pre-Offer Defenses Description
Blank

Shark-repellent charter
amendments:
Staggered (or classified) board The board is classified into three equal groups. Only one group is elected each year.
Therefore, the bidder cannot gain control of the target immediately.
Supermajority A high percentage of shares, typically 80%, is needed to approve a merger.
Fair price Mergers are restricted unless a fair price (determined by formula or appraisal) is paid.
Restricted voting rights Shareholders who acquire more than a specified proportion of the target have no
voting rights unless approved by the target’s board.
Waiting period Unwelcome acquirers must wait for a specified number of years before they can
complete the merger.
Blank

Other:
Poison pill Existing shareholders are issued rights that, if there is a significant purchase of
shares by a bidder, can be used to purchase additional stock in the company at a
bargain price.
Poison put Existing bondholders can demand repayment if there is a change of control as a
result of a hostile takeover.

Post-Offer Defenses Description

Litigation Target files suit against bidder for violating antitrust or securities laws.
Asset restructuring Target buys assets that bidder does not want or that will create an antitrust problem.
Liability restructuring Target issues shares to a friendly third party, increases the number of shareholders,
or repurchases shares from existing shareholders at a premium.

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 Merger Waves and Merger Profitability
Who usually benefits from the merger?
• Shareholders of the target.
• Lawyers and brokers.
• The executives of the acquiring firm.
Who usually loses in a merger?
• Shareholders of the acquiring firm due to overpayment.
• Executives of the target.
• Employees due to restructuring.
• Customers, if competition is reduced.
• Bondholders, if the merger is debt financed.

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 Figure 32.2 The Number of Mergers Involving
U.S. Companies, 1985–2020

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