Mergers and Acquisitions Arzac, Chapter 9

Mergers many people including Warren Buffett have expressed skepticism of the power of mergers: Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T(arget) … Investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads… We have tried occasionally to buy toads at bargain prices with results that have been chronicled in past reports. Clearly our kisses fell flat. We have done well with a couple of princes – but they were princes when purchased. At least our kisses didn’t turn them into toads. And, finally, we have occasionally been quite successful in purchasing fractional interests in easily identifiable princes at toadlike prices.

M&As changing forces driving mergers: mergers vs. tender offers types technological change globalization and freer trade deregulation economies of scale, scope, and technological catch-up change in industry organization individual entrepreneurship macroeconomic factors ** Weston, Siu, and Johnson (2001) mergers vs. tender offers types

Changes in Ownership Structure exchange offers leverage recapitalizations dual-class recapitalizations share repurchases LBOs, MBOs ESOPS

Control of Decision Powers compensation arrangements proxy contest premium buy-backs (greenmail) takeover defenses stakeholder relationships ethics and reputation

Theories of Mergers efficiency increases (restructuring) operating synergies financial synergy information hubris agency problems

Forms of Transaction merger acquisition tax implications of assets of stock tax implications legal implications

Form of Transaction stock purchase asset purchase merger avoids tax at corporate level acquirer can use NOL of target sh of target taxed on capital gain acquirer can not step-up basis of target’s assets for tax purposes asset purchase seller is subject to corporate taxes buyer can step-up basis and amortize goodwill over 15 years buyer can not use NOLs of target merger forward merger reverse subsidiary merger

Example 1 Assume the buyer acquires a debt-free target for $100 cash, the target’s tax basis in the assets is $40, the target shareholders’ basis in the stock is $15, and the fair MV of the stock was $70 prior to the acquisition. Let the corporate tax rate be 40%, the personal tax rate on capital gains be 20%, and assume that all the gain to the seller is classified as capital gain and the buyer’s price in excess of the target’s basis is allocated to goodwill. Look at the proceeds to the target using both a stock purchase and an asset purchase. Review Example 2 and 3 in the text.

Returns in M&As Kaplan and Weisbach (1992), Servaes (1991), and Mulherin and Boone (2000) mergers in banking industry Becher (2000) – looked at because of increased number of bank mergers that occurred around industry deregulation evidence that bank mergers created wealth target returns bidder returns

Value of Mergers VC = VA + VT + Synergies – Cash Premium = PT – VT Premium = pc*m + cash Acquirer’s Gain = Synergies – Premium Acquirer’s Gain + Seller’s Gain = Synergies pC = VC / (n + m) or pC = (VA + VT + Synergies – Cash)/(n + m) where n = # of old shares of acquirer and m = # of shares issued to target shareholders Break-Even Synergies = Premium = mpA + Cash – VT GainA = Synergy - Premium

Accretion/Dilution Analysis alternate way to look at the impact of the merger to the shareholders of the acquirer find pro-forma EPS for merged firm for year prior to merger and then years after also for share exchange, combine NI and divide by new number of shares outstanding if new EPS is > EPS of acquirer, then there is accretion if new EPS < EPS of acquirer, then there is dilution

Merger Analyses terms of the merger financing the merger break-even synergies financial model of the merger accretion-dilution analysis free cash-flow valuation stress-testing and scenario analysis

B’s acquisition of T B T Pre-announcement stock price $ 30 $ 22 $ 30 $ 22 Net income (million) $ 80 $ 37.50 Shares outstanding (million) 40 15 EPS $ 2.00 $ 2.50 P/E 8.8 Market value (million) $1200 $330