Chapter 26 mergers and acquisitions

Key Concepts and Skills• Be able to define the various terms associated with M&A activity • Understand the various reasons for mergers and acquisitions and whether or not these reasons a

Chapter 26 Mergers and Acquisitions

Key Concepts and Skills

• Be able to define the various terms associated with M&A activity

• Understand the various reasons for mergers and acquisitions and whether or not these reasons are

in the best interest of shareholders

• Understand the various methods for paying for an acquisition and how to account for it

• Understand the various defensive tactics that are available

Chapter Outline

• The Legal Forms of Acquisitions

• Taxes and Acquisitions

• Accounting for Acquisitions

• Gains from Acquisition

• Some Financial Side Effects of Acquisitions

• The Cost of an Acquisition

• Defensive Tactics

• Some Evidence on Acquisitions: Do M&A Pay?

Merger versus Consolidation

• Merger

– One firm is acquired by another– Acquiring firm retains name and acquired firm ceases to exist

– Advantage – legally simple– Disadvantage – must be approved by stockholders of both firms

• Consolidation

– Entirely new firm is created from combination

of existing firms

– May be delayed if some target shareholders hold out for more money – complete absorption requires a merger

• Classifications

– Horizontal – both firms are in the same industry – Vertical – firms are in different stages of the production process – Conglomerate – firms are unrelated

• Tax-free acquisition

– Business purpose; not solely to avoid taxes – Continuity of equity interest – stockholders of target firm must be able to maintain an equity interest in the

combined firm – Generally, stock for stock acquisition

Accounting for Acquisitions

• Pooling of interests accounting no longer allowed

of the assets has decreased

combined assets more effectively

• This is generally a good reason for a merger

• Examine whether the synergies create enough benefit to justify the cost

Revenue Enhancement

• Marketing gains

– Advertising – Distribution network – Product mix

• Strategic benefits

• Market power

Cost Reductions

• Economies of scale

– Ability to produce larger quantities while reducing the average per unit cost

– Most common in industries that have high fixed costs

• Economies of vertical integration

– Coordinate operations more effectively – Reduced search cost for suppliers or customers

• Complimentary resources

• Take advantage of net operating losses

– Carry-backs and carry-forwards – Merger may be prevented if the IRS believes the sole purpose is to avoid taxes

• Unused debt capacity

• Surplus funds

– Pay dividends – Repurchase shares – Buy another firm

• Asset write-ups

Reducing Capital Needs

• A merger may reduce the required investment in working capital and fixed assets relative to the two firms operating separately

• Firms may be able to manage existing assets more effectively under one umbrella

• Some assets may be sold if they are redundant in the combined firm (this includes reducing human capital as well)

General Rules

• Do not rely on book values alone – the market provides information about the true worth of assets

• Estimate only incremental cash flows

• Use an appropriate discount rate

• Consider transaction costs – these can add up quickly and become a substantial cash outflow

of a larger firm and is not true growth

• In this case, the P/E ratio should fall because the combined market value should not change

• There is no free lunch

More (Colorful) Terms

• Fair price provision

• Dual class capitalization

Divestitures and Restructurings

• Divestiture – company sells a piece of itself to another company

• Equity carve-out – company creates a new company out of a subsidiary and then sells a minority interest to the public through an IPO

• Spin-off – company creates a new company out

of a subsidiary and distributes the shares of the new company to the parent company’s

stockholders

• Split-up – company is split into two or more companies, and shares of all companies are distributed to the original firm’s shareholders

Quick Quiz

• What are the different methods for achieving a takeover?

• How do we account for acquisitions?

• What are some of the reasons cited for mergers? Which may be in stockholders’ best interest, and which generally are not?

• What are some of the defensive tactics that firms use to thwart takeovers?

• How can a firm restructure itself? How do these methods differ in terms of ownership?

Ethics Issues

• In the case of takeover bids, insider trading is argued to be particularly endemic because of the large potential profits involved and because of the relatively large number of people “in on the

Comprehensive Problem

• Two identical firms have yearly after-tax cash flows of $20 million each, which are expected to continue into perpetuity If the firms merged, the after-tax cash flow of the combined firm would be

$42 million Assume a cost of capital of 12%

– Does the merger generate synergy?

– What is V B *?

– What is ΔV?

End of Chapter