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Chapter 17 Mergers and Acquisitions

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1 Chapter 17 Mergers and Acquisitions

2 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

3 Figure 17-1 Basic Business Combinations

4 Mergers and Acquisitions
Relationships Consolidation implies the firms combined willingly Acquisition can be a friendly or hostile takeover Stockholders Must be willing to give up their shares for the offered price Approval from majority necessary for acquisition to be successful

5 Mergers and Acquisitions
Friendly Procedure Target firm's management approves and cooperates with acquiring company Negotiation occurs until agreement is reached Proposal submitted for stockholder vote Unfriendly Procedure Target firm's management resists, takes defensive measures to stop takeover Acquiring firm makes a tender offer to the target's shareholders

6 Why Unfriendly Mergers are Unfriendly
A target's management may resist a takeover because: Acquiring firm offered too low a price for the stock Target’s management often loses jobs, power, and influence

7 Economic Classification of Business Combinations
Vertical Merger Acquiring suppliers of customers Horizontal Merger Merging firms are competitors Congeneric Merger Firms are in related but not competing businesses Conglomerate Merger Firms are in entirely different fields

8 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

9 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

10 The Antitrust Laws U.S. is committed to a competitive economy
Antitrust laws (enacted s) prohibit certain activities that can reduce competitive nature of the economy Mergers have potential to reduce competition

11 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 Variations in different business lines offset each other

12 The Reasons Behind Mergers
Economies of Scale Guaranteed Sources and Markets Acquiring Assets Cheaply Tax Losses Ego and Empire

13 Tax Losses Combined Businesses pay less total tax.
But IRS will not recognize if sole purpose is to reduce tax. Rich Inc. Poor Inc. Merged EBT $2,000 ($1,000) $1,000 Tax (35%) 700 -0- 350 Net Income $1,400 ($1,000) $650

14 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

15 The History of Merger Activity in the U.S.
Wave 1: The Turn of the Century, Horizontal mergers transformed the U.S. into a nation of industrial giants, with some monopolies  Wave 2: The Roaring Twenties, Began with World War I and ended with the stock market crash of 1929 Horizontal mergers led to oligopolies

16 The History of Merger Activity in the U.S.
Wave 3: The Swinging Sixties, 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

17 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

18 Mergers since the 1980s Mergers since the 1980s are characterized by:
Large Size Global Horizontal mergers and antitrust Easy financing Hostility Raiders Defenses Advisors

19 Megamergers since the 1980s
Companies Year Industry $ Size Citicorp and Travelers 1988 Financial Services $140 billion MCI and WorldCom 1998 Telecom $ 37 billion Daimler-Benz and Chrysler Automotive $ 75 billion AOL and Time Warner 2000 Media and Entertainment $ 350 billion Hewlett-Packard and Compaq 2001 Computer hardware $ 25 billion

20 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

21 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

22 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

23 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

24 Merger Analysis and the 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

25 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

26 Calculating a Price and the Problem of Terminal Values
Remember In merger analysis, C0 is the amount acquirer will pay for the target’s stock If the merger is to make sense for the acquirer, C0 must be no more than the sum of the PVs of all the other Cs The maximum price makes NPV=0

27 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 a share of Beta’s stock?

28 Concept Connection Example 17-1 Basic Merger Analysis
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

29 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 Such assumptions are terminal values over

30 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

31 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

32 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

33 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 shareholders to the target’s shareholders

34 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

35 Defensive Tactics: In Anticipation of a Takeover
Staggered Election of Directors Approval by a supermajority Poison pills Golden parachutes Accelerated debt Share rights plans

36 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

37 Proxy Fights Proxy - a legal document giving one person the right to act for another on a certain issue Proxy fight - opposing groups solicit shareholders’ proxies to elect directors

38 Divestitures 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

39 Divestitures 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

40 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

41 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 Reorganization

42 Bankruptcy Procedures—Reorganization, Restructuring, Liquidation
Liquidate Insolvent company deemed unrecoverable will liquidate Assets will be sold under the court's supervision, with proceeds to pay creditors according to priority Reorganize Insolvent company perceived as recoverable will reorganize Debt will be restructured and a plan developed to pay creditors as fairly as possible

43 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 protect the interests of its creditors

44 Reorganization A plan under which an insolvent firm continues to operate while attempting to pay off its debts Reorganization plans are judged on fairness and feasibility Fairness—claims are satisfied based on priorities Feasibility—likelihood the plan will actually work Plan must be approved by the bankruptcy court, firm's creditors and stockholders

45 Debt Restructuring Involves concessions that lower an insolvent firm’s payments so it can continue to operate Can be accomplished in two ways: Extension Composition Creditors have an incentive to compromise because if the firm fails they are likely to receive even less

46 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

47 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 200 Depreciation ($400) Net Income --- Tax $8,000 Total capital EBT 2,000 Equity 600 Interest $6,000 Debt $200 EBIT Capital Income 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.

48 Concept Connection Example 17-4 Debt Restructuring in Bankruptcy
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 200 Depreciation ($100) Net Income --- Tax $8,000 Total capital EBT 5,000 Equity 300 Interest $3,000 Debt $200 EBIT Capital Income 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.

49 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

50 Liquidation Claimants include Vendors - who sold to the firm on credit
Employees – who are owed wages Customers - deposits for merchandise Government - owed taxes Lawyers and the court Stockholders - receive whatever is left

51 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

52 Bankruptcy Code Chapters
Liquidation Chapter 11 Reorganization Notice that Bankruptcy is a Federal court procedure, not state Although some state laws do apply


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