1 - 0 Advanced Accounting by Debra Jeter and Paul Chaney Chapter 1: Introduction to Business Combinations Slides Authored by Hannah Wong, Ph.D. Rutgers University

1 - 1 Types of Business Combinations Friendly Combinations l Boards of directors of combining companies negotiate terms of proposed combination.

1 - 2 Types of Business Combinations Unfriendly (Hostile) Combinations l Board of directors of target company resists the combination. l The acquiring company deals directly with individual shareholders through a tender offer.

1 - 3 Defense Tactics l Poison pill: stock rights of shareholders to purchase additional shares at a bargain price in the event of a potential takeover. l Greenmail: purchase of shares held by acquiring company at a premium price.

1 - 4 Defense Tactics l White knight or white squire: encourage a friendly firm to acquire the target company. l Selling the crown jewels: sale of valuable assets to make the firm less attractive. l Leveraged buyout: managers and investors purchase controlling interests and take the firm private.

1 - 5 Business Combinations: Why? l Operating synergies l Competitiveness in the international marketplace l Financial synergy l Diversification l Divestitures ? ? ? ? ?

1 - 6 Business Combinations: Why Not? l Insufficient management control over the resulting conglomerate, resulting in future divestitures. l Business combinations may enable suboptimal allocation of capital. l Accounting method may encourage firms to pay too much.

1 - 7 Business Combinations: Historical Perspective l : horizontal integration l : vertical integration l1945-present: merger mania n 1970s: conglomerate mergers n 1980s - present: strategic acquisitions

1 - 8 Types of Combinations Net assets of S Company What is acquired: Combination of above Stock Debt Cash Common stock of S Company Pooling of Interests Method Purchase Method What is given up:How it is accounted for:

1 - 9 Stock Acquisition VS Asset Acquisition Stock Acquisition lmay obtain control by acquiring 50% of voting common stock lcan avoid formal negotiation with target management lmaintain separate legal entity n limited liability n greater flexibility in filing tax returns n regulations apply to one firm only Asset Acquisition lmust acquire 100% of target firm, hence higher cost lneed to negotiate with target management lno separate legal entity

Types of Combinations A CompanyB Company A Company + B Company C Company + Financial Statements of A Company Financial Statements of B Company Consolidated Financial Statements of A and B Companies + Statutory Merger Statutory Consolidation Stock Acquisition

Determining Price lPrice n effect of acquisition on future earnings n value of the firm’s identifiable net assets n estimated value of implied goodwill lStock exchange ratio n number of shares of acquiring company to be exchanged for each share of the acquired company

Determining Method of Payment lCash or stock? lFactors affecting method of payment: n liquidity position of acquiring firm n willingness of sellers to accept alternative forms of payment n tax and accounting issues

Estimate Implied Goodwill By discounting expected future excess earnings n identify normal rate of return for similar firms n apply rate of return to net assets of target firm to estimate normal earnings n estimate expected future earnings of target n excess earnings = expected normal earnings earnings n goodwill = discounted value of excess earnings -

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