Practical financial managment 7e LASHER chapter 17

Mergers and Acquisitions Merger – a combination of two or more businesses under one ownership Acquisition or Takeover - one firm acquires the stock of another – Acquired firm is the ta

Mergers and Acquisitions

Merger – a combination of two or more businesses under one ownership

Acquisition or Takeover - one firm

acquires the stock of another

– Acquired firm is the target

Consolidation - combining firms

dissolve forming a new legal entity

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Figure 17-1 Basic Business Combinations

Mergers and Acquisitions

Mergers and Acquisitions

measures to stop takeover

– Acquiring firm makes

a tender offer to the target's shareholders

Why Unfriendly Mergers

– Target’s management often loses jobs,

power, and influence

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Economic Classification of Business Combinations

A Further Classification

Strategic Merger

– Merger is undertaken to enhance

the acquirer’s business position

Financial Merger

– Merger is undertaken to make

money from the merger process

Role of Investment Banks

Help companies issue securities

Instrumental in acting as advisors to acquiring companies

Assist in establishing a value for target

Help acquiring firm raise money for

acquisition

Advise reluctant targets on defensive measures

The Antitrust Laws

U.S is committed to a competitive

The Reasons Behind Mergers

Synergies

– Combined performance is expected to be better than the

sum of the separate performances

– Usually cost saving or marketing opportunities

Growth

– External growth through acquisition is faster than internal

growth

Diversification to Reduce Risk

– Collection of diverse businesses less risky than a single

line

The Reasons Behind Mergers

Tax Losses

Combined Businesses pay less total tax.

But IRS will not recognize if sole purpose is to reduce tax.

$650 ($1,000)

$1,400 Net Income

350 -0-

700 Tax (35%)

$1,000 ($1,000)

$2,000 EBT

Merged Poor Inc.

Rich Inc.

Holding Companies

Corporation that owns other corporations

– Companies owned are subsidiaries

– Holding company is the parent of the subsidiary

Advantages

– Keeps business operations separate and

distinct

– Can keep liabilities of subsidiaries separate

– It’s possible to control a subsidiary without

owning all of its stock

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The History of Merger Activity in the U.S

Wave 1: The Turn of the Century, 1897-1904

– Horizontal mergers transformed the U.S

into a nation of industrial giants, with some monopolies

Wave 2: The Roaring Twenties, 1916-1929

– Began with World War I and ended with the

stock market crash of 1929

– Horizontal mergers led to oligopolies

The History of Merger Activity in the U.S

Wave 3: The Swinging Sixties, 1965-1969

– Conglomerate mergers - unrelated fields

– Stock market driven

An Important Development During the 1970s

– Hostile takeovers uncommon prior to 1970s

– 1974 INCO acquires ESB assisted by respected

investment bank Morgan Stanley

– After that hostile takeovers became acceptable

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The History of Merger Activity in the U.S.

Wave 4: Megamergers, 1981 – 1990

– Very large firms, often industry leaders, merge

Wave 5: Globalization, 1992 – 2000

– Began after 1991 – 1992 recession

– Large number of international mergers

– Ended with September 11, 2001

Wave 6: Private Equity, 2003 – 2008

– Private equity groups bought companies for financial reasons – Ended with the financial crisis of 2008

Mergers since the 1980s

Mergers since the 1980s are characterized by:

Megamergers since the 1980s

Companies Year Industry $ Size

Citicorp and Travelers 1988 Financial Services $140 billionMCI and WorldCom 1998 Telecom $ 37 billionDaimler-Benz and Chrysler 1998 Automotive $ 75 billionAOL and Time Warner 2000 Media and Entertainment $ 350 billionHewlett-Packard and Compaq 2001 Computer hardware $ 25 billion

Social, Economic, and

Political Effects

Large mergers have implications

regarding the concentration of power and influence

– Anti-competitiveness of merging large

companies

– Concentrates economic power in the

hands of a few

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Merger Analysis and the

Price Premium

What is the most an acquiring

company should pay for a target in total and per share?

– Merger analysis attempts to answer this

question

– Acquiring firm forecasts the target's

cash flows and chooses appropriate

discount rate

Merger Analysis and the

Price Premium

Estimating Merger Cash Flows

– Should be a straightforward cash flow estimation with two exceptions

Adjustments for expected synergies

Adjustments for reinvestment necessary to support growth

– Pitfalls of estimating cash flows

May not have access to the target's detailed information

about future prospects or the past

Uncertainty of future

Biases of people making estimates

– Acquirer tends to overestimate target’s value

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Merger Analysis

Appropriate Discount Rate

– An acquisition is an equity transaction

– Use target’s estimated equity rate (CAPM)

Value to the Acquirer is the PV of estimated cash flows from target

– Maximum value makes NPV=0 if viewed in capital

budgeting terms

Payment for target’s stock is C0 – the initial outlay

Maximum Per-share Price is Maximum PV ÷

number shares

Merger Analysis and the

Price Premium

Price Premium

– The price offered to target shareholders

must be higher than the stock's market price

High enough to induce stockholders to sell now

Offering price exceeds the current market price by the price premium

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The Price Premium

Effect on market price

– Certainty of a premium creates a

speculative opportunity

– Investor strategy - buy stock in potential

takeover targets to get premium

– Size of Premium is the Point of

negotiations

Remember: Insider trading illegal

Calculating a Price and the Problem of

The maximum price makes NPV=0

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Concept Connection Example 17-1

Basic Merger Analysis

Alpha is interested in acquiring Beta The appropriate interest rate for the analysis is 12%

Beta’s cash flows including synergies are estimated for the next three years as follows ($000).

Beta has 12,000 shares of stock outstanding

What is the maximum price Alpha should be willing to pay for

Concept Connection Example 17-1

Basic Merger Analysis

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Solution: T he PV of Beta’s cash flows is:

The maximum Alpha should pay for all of Beta’s stock is $531,914 the maximum per share price Alpha should be willing to pay is:

Maximum acquisition price = $531,914/12,000 = $44.33

Merger Analysis with Terminal Values

Justifying a merger based on a few years of cash flows can be difficult

Acquisition looks better by assuming cash flows after the last year E.g.

– Sale of the target at a high price

– Continuing operating cash flows for a long time

or indefinitely

Constant

Growing

Terminal Values (TVs)

TVs can overwhelm detailed forecast.

– Especially an infinite stream of income

TV is valued as the PV of a perpetuity starting at end of detailed forecast.

– TVs are favored by people who want the

acquisition for non financial reasons

– It’s up to Finance (CFO) to keep the

assumptions reasonable

Terminal Value assumptions often lead

to overpaying for an acquisition

Paying for the Acquisition The Junk Bond Market

Acquiring firm pays the target firm:

– Cash – have it or raise it

– Stock in the acquiring firm

– Debt of the acquiring firm

Junk bond market began in the 1980s and has helped firms raise cash to

finance many mergers

Paying for the Acquisition The Junk Bond Market

Junk bonds are low quality (risky) bonds

that pay high yields

Prior to 1980s small, risky companies could not borrow via bonds

– Investment bankers pooled risky bonds

into funds creating the junk bond market

– The idea collapsed in the late 1980s

Since 1990’s, high yield debt has reemerged

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The Capital Structure Argument to

Justify High Premiums

Using debt to raise cash for buying out a

target's stockholders, makes the firm more leveraged

– It can be argued that this increases its value

See Chapter 14 on capital structure and leverage

-The Effect of Paying Too Much

– An acquiring firm that pays too much for a

target transfers value from its

Defensive Tactics:

After a Takeover is Underway

Defensive Tactics are things targets

do to keep from being acquired

Tactics After a Takeover is Under Way

– Challenge the price

– Claim an antitrust violation

– Issue debt and repurchase shares

– Seek a white knight

– Greenmail

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Defensive Tactics:

In Anticipation of a Takeover

Tactics in Anticipation of a Takeover

– Staggered Election of Directors

Leveraged Buyouts (LBOs)

Investors take a company private by buying all of its stock largely using

borrowed money

– Then attempts to work down the debt

Tends to be risky due to high debt

burden

Less common today than in the 1980s

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A company decides to get rid of a particular business operation

– Reasons for divestitures

A firm needs cash

A division may not fit strategically into the firm's long-term plans

Poor performance

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Methods of Divesting Companies

– Sale for cash and/or securities

– Spin-off —creates a new company

owned by the same stockholders, can trade separately

– Liquidation —the divested business is

closed down and its assets sold

Failure and Insolvency

Economic failure —a firm is unable to

provide adequate return to its stockholders

Commercial failure —a business cannot

pay its debts (insolvent)

A business can be an economic failure

without being a commercial failure

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Bankruptcy Concept and Objectives

Bankruptcy – protects a failing firm

from creditors until a resolution is

reached to close or continue it

Bankruptcy court protects a firm from its creditors and determines whether

it should shut down or continue

– Liquidation

Assets will be sold under the court's supervision, with proceeds to pay creditors according to priority

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Bankruptcy Procedures—Reorganization, Restructuring,

Liquidation

Bankruptcy petition can be initiated

– voluntarily by insolvent company or

– involuntarily by its creditors

A firm in bankruptcy is usually allowed to continue operations

– Trustee oversees the firm’s operations to

Debt Restructuring

Involves concessions that lower an

insolvent firm’s payments so it can

Debt Restructuring

Debt-to-equity conversions are a

common method of restructuring debt

– Creditors give up debt claims in return

for stock in the company

– Equity may be worth more in the long

run than the debt given up

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Concept Connection Example 17-4

Debt Restructuring in Bankruptcy

Adcock has 50,000 shares of common stock outstanding at a book value

of $40, pays 10% interest on its debt, and is in the following financial

situation

($300)Cash flows

(100)Principal Repayment

200Depreciation

($400)Net Income

Tax

-$8,000Total capital

($400)EBT

2,000Equity

600Interest

$6,000Debt

$200EBIT

CapitalIncome and Cash Flow

Notice that although the company has positive EBIT, it doesn't earn enough

to pay its interest let alone repay principal on schedule Without help

of some kind it will fail shortly Devise a composition involving a debt for equity conversion that will

keep the firm afloat.

Concept Connection Example 17-4

Debt Restructuring in Bankruptcy

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Suppose creditors are willing to convert $3 million in debt to equity at the

$40 book value Requires issuing 75,000 new shares, resulting in the

following financial situation

($50)Cash flows

(50)Principal Repayment

200Depreciation

($100)Net Income

Tax

-$8,000Total capital

($100)EBT

5,000Equity

300Interest

$3,000Debt

$200EBIT

CapitalIncome and Cash Flow

Notice that the company now has a slightly positive cash flow and can at least theoretically continue in business indefinitely However, creditors now own a controlling interest in the firm.

Liquidation

Closing a troubled firm and selling its assets

Trustee attempts to recover any unauthorized transfers out of the firm

Trustee supervises the sale of the assets, pools and distributes the funds

– Lawyers and the court

– Stockholders - receive whatever is left

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Distribution Priorities

Bankruptcy code contains priorities for the distribution of assets among claimants

Priority code payoffs of unsecured claimants:

– Administrative expenses of the bankruptcy proceedings

– Certain business expenses incurred after the bankruptcy petition is filed – Certain unpaid wages

– Certain unpaid contributions to employee benefit plans

– Certain customer deposits

– Unpaid taxes

– Unsecured creditors

– Preferred stockholders

– Common stockholders

Bankruptcy Code Chapters