1. 0 Mergers and Acquisitions Forms of Takeovers The Basic Forms of Acquisitions The Tax Forms of Acquisitions Accounting for Acquisitions Determining the Synergy from an Acquisition Source of Synergy from Acquisitions A Cost to Stockholders from Reduction in Risk Two "Bad" Reasons for Mergers The NPV of a Merger Defensive Tactics Some Evidence on Acquisitions Summary and Conclusions

2. 1 Varieties of Takeovers Takeovers Acquisition Proxy Contest Going Private (LBO) Merger Acquisition of Stock Acquisition of Assets

3. 2 The Basic Forms of Acquisitions There are three basic legal procedures that one firm can use to acquire another firm: –Merger or Consolidation –Acquisition of Stock –Acquisition of Assets

4. 3 What are some merger-related activities of investment bankers? Identifying targets Arranging mergers Developing defensive tactics Establishing a fair value Financing mergers Arbitrage operations

5. 4 Do mergers really create value? According to empirical evidence, acquisitions do create value as a result of economies of scale, other synergies, and/or better management. Shareholders of target firms reap most of the benefits, that is, the final price is close to full value. –Target management can always say no. –Competing bidders often push up prices.

6. Average Acquisition Premium and Stock Price Reactions to Mergers 5

7. 6 What method is used to account for mergers? Pooling of interests is GONE. Only purchase accounting may be used now.

8. 7 Purchase Accounting Purchase: –The assets of the acquired firm are “written up” to reflect purchase price if it is greater than the net asset value. –Goodwill is often created, which appears as an asset on the balance sheet. –Common equity account is increased to balance assets and claims.

9. 8 Goodwill Amortization Goodwill is NO LONGER amortized over time for shareholder reporting. Goodwill is subject to an annual “impairment test.” If its fair market value has declined, then goodwill is reduced. Otherwise it is not. Goodwill is still amortized for Federal Tax purposes.

10. 9 The Tax Forms of Acquisitions If it is a taxable acquisition, selling shareholders need to figure their cost basis and pay taxes on any capital gains. If it is not a taxable event, shareholders are deemed to have exchanged their old shares for new ones of equivalent value.

11. Types of Mergers 10 Horizontal merger –Target and acquirer are in the same industry Vertical merger –Target’s industry buys from or sells to acquirer’s industry Conglomerate merger –Target and acquirer operate in unrelated industries

12. Types of Mergers 11 Stock Swap –Target shareholders are swapping old stock for new stock in either the acquirer or a newly created merged firm Term sheet –Summary of price and method of payment –Consideration paid to target shareholders can be very complex

13. 12 What are some valid economic justifications for mergers? Synergy: Value of the whole exceeds sum of the parts. Could arise from: –Operating economies –Financial economies –Differential management efficiency –Taxes (use accumulated losses)

14. Reasons to Acquire 13 Large synergies are by far the most common justification that bidders give for the premium they pay for a target. –Such synergies usually fall into two categories: cost reductions and revenue enhancements. Cost-reduction synergies are more common and easier to achieve because they generally translate into layoffs of overlapping employees and elimination of redundant resources. Revenue-enhancement synergies, however, are much harder to predict and achieve.

15. Economies of Scale and Scope 14 Economies of Scale –The savings a large company can enjoy from producing goods in high volume, that are not available to a small company Economies of Scope –Savings large companies can realize that come from combining the marketing and distribution of different types of related products –A cost associated with an increase in size is that larger firms are more difficult to manage.

16. Efficiency Gains 15 Another justification acquirers cite for paying a premium for a target is efficiency gains, which are often achieved through an elimination of duplication. –Acquirers often argue that they can run the target organization more efficiently than existing management could. Although identifying poorly performing corporations is relatively easy, fixing them is another matter entirely.

17. Tax Savings from Operating Losses 16 A conglomerate may have a tax advantage over a single-product firm because losses in one division can offset profits in another division. –To justify a takeover based on operating losses, management would have to argue that the tax savings are over and above what the firm would save using carry-back and carry- forward provisions.

18. Diversification 17 Risk Reduction –Like a large portfolio, large firms bear less unsystematic risk, so often mergers are justified on the basis that the combined firm is less risky. A problem with this argument is that it ignores the fact that investors can achieve the benefits of diversification themselves by purchasing shares in the two separate firms.

19. Diversification 18 Debt Capacity and Borrowing Costs –All else being equal, larger firms are more diversified, and therefore have a lower probability of bankruptcy. The argument is that with a merger, the firm can increase leverage and thereby lower their costs of capital. –Due to market imperfections like bankruptcy, a firm may be able to increase its debt and enjoy greater tax savings without incurring significant costs of financial distress by merging and diversifying. –Gains must be large enough to offset any disadvantages of running a larger, less focused firm

20. Diversification 19 Liquidity –Shareholders of private companies often have a disproportionate share of their wealth invested in the private company. –The liquidity that the bidder provides to the owners of a private firm can be valuable and often is an important incentive for the target shareholders to agree to the takeover.

21. Earnings Growth 20 It is possible to combine two companies with the result that the earnings per share of the merged company exceed the pre- merger earnings per share of either company, even when the merger itself creates no economic value.

22. 21 Two "Bad" Reasons for Mergers Earnings Growth –Only an accounting illusion. Diversification –Shareholders who wish to diversify can accomplish this at much lower cost with one phone call to their broker than can management with a takeover.

23. 22 Determining the Synergy from an Acquisition Most acquisitions fail to create value for the acquirer. The main reason why they do not lies in failures to integrate two companies after a merger. –Intellectual capital often walks out the door when acquisitions aren't handled carefully. –Traditionally, acquisitions deliver value when they allow for scale economies or market power, better products and services in the market, or learning from the new firms.

24. 23 Synergy Suppose firm A is contemplating acquiring firm B. The synergy from the acquisition is Synergy = V AB – (V A + V B ) The synergy of an acquisition can be determined from the usual discounted cash flow model:  CF t =  Rev t –  Costs t –  Taxes t –  Capital Requirements t Synergy =  CF t (1 + r) t  t = 1 T where

25. 24 Source of Synergy from Acquisitions Revenue Enhancement Cost Reduction –Including replacement of ineffective managers. Tax Gains –Net Operating Losses –Unused Debt Capacity Incremental new investment required in working capital and fixed assets  CF t =  Rev t –  Costs t –  Taxes t –  Capital Requirements t

26. 25 Calculating the Value of the Firm after an Acquisition Avoiding Mistakes –Do not Ignore Market Values –Estimate only Incremental Cash Flows –Use the Correct Discount Rate –Don’t Forget Transactions Costs

27. 26 A Cost to Stockholders from Reduction in Risk The Base Case –If two all-equity firms merge, there is no transfer of synergies to bondholders, but if… One Firm has Debt –The value of the levered shareholder’s call option falls. How Can Shareholders Reduce their Losses from the Coinsurance Effect? –Retire debt pre-merger.

28. 27 The NPV of a Merger Typically, a firm would use NPV analysis when making acquisitions. The analysis is straightforward with a cash offer, but gets complicated when the consideration is stock.

29. 28 The NPV of a Merger: Cash NPV of merger to acquirer = Synergy – Premium Premium = Price paid for B – V B NPV of merger to acquirer = Synergy – Premium Synergy = V AB – (V A + V B ) = [V AB – (V A + V B )] – [Price paid for B – V B ] = V AB – (V A + V B ) – Price paid for B + V B = V AB – V A – Price paid for B

30. 29 The NPV of a Merger: Common Stock The analysis gets muddied up because we need to consider the post-merger value of those shares we’re giving away.

31. 30 Some Evidence on Acquisitions: The Short Run TakeoverSuccessfulUnsuccessful TechniqueTargetsBiddersTargetsBidders Tender offer 30%4%–3% – 1% Merger 20%0%–3% – 5% Proxy contest 8%NA 8%NA

32. Twenty Largest Merger Transactions, 1998–2012 31

33. Percentage of Public Companies Taken Over Each Quarter, 1926–2012 32

34. 33 Some Evidence on Acquisitions: The Long Run In the long run, the shareholders of acquiring firms experience below average returns. Cash-financed mergers are different than stock- financed mergers. Acquirers can be friendly or hostile. The shares of hostile cash acquirers outperformed those of friendly cash acquirers. One explanation is that unfriendly cash bidders are more likely to replace poor management.

35. 34 Summary and Conclusions The three legal forms of acquisition are 1.Merger and consolidation 2.Acquisition of stock 3.Acquisition of assets M&A requires an understanding of complicated tax and accounting rules. The synergy from a merger is the value of the combined firm less the value of the two firms as separate entities. Synergy = V AB – (V A + V B )

36. 35 Summary and Conclusions The possible synergies of an acquisition come from the following: –Revenue enhancement –Cost reduction –Lower taxes –Lower cost of capital The reduction in risk may actually help existing bondholders at the expense of shareholders.