FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTER CHAPTER TWENTY-SIX TWENTY-SIX Mergers and Acquisitions

Learning Objectives 1. Identify the four types of external expansion that a company may pursue. 2. Define synergy, and explain what effect it can have on a merged company. 3. Describe some of the consequences for the acquiring company when it is paying more than the current market price for the shares of the firm it is taking over.

Learning Objections 4. Identify the accounting concerns in an acquisition, and discuss some of their implications. 5. Discuss the major concerns involving corporate concentration, declining competition, increased debt loads, insider trading, and other such topics.

Introduction Firms grow by generating new internal investments or by acquiring businesses through external expansion Firms grow by generating new internal investments or by acquiring businesses through external expansion The framework for analyzing business combinations is similar to capital budgeting The framework for analyzing business combinations is similar to capital budgeting Business combinations can take the form of: Business combinations can take the form of: Holding companies – a firm’s assets are shares of other companies (BCE, CP, ONEX) Holding companies – a firm’s assets are shares of other companies (BCE, CP, ONEX) Mergers – two firms come together, with one losing its corporate identity and being absorbed by the other Mergers – two firms come together, with one losing its corporate identity and being absorbed by the other Amalgamations – also called consolidations, they are common between equals Amalgamations – also called consolidations, they are common between equals

Motives for Business Combinations The main motive for business combination should be to enhance shareholder wealth The main motive for business combination should be to enhance shareholder wealth The factors that create shareholder wealth vary and are reflected through several directions external growth can take, which include: The factors that create shareholder wealth vary and are reflected through several directions external growth can take, which include: Horizontal expansion – when a firm acquires competitors that produce or distribute similar products Horizontal expansion – when a firm acquires competitors that produce or distribute similar products Vertical integration – occurs when successive stages of operation are integrated Vertical integration – occurs when successive stages of operation are integrated

Motives for Business Combinations Circular expansion – brings different products together that can be handled by similar technologies or distributed channels Circular expansion – brings different products together that can be handled by similar technologies or distributed channels Conglomerate expansion – involves companies with products or businesses that bear no relation to one another Conglomerate expansion – involves companies with products or businesses that bear no relation to one another Synergy Synergy exists when the value of the combined company exceeds the sum of the value of the two firms being merged exists when the value of the combined company exceeds the sum of the value of the two firms being merged can arise from economies of scale can arise from economies of scale the greatest synergies involve intangible assets the greatest synergies involve intangible assets

Motives for Business Combinations Improved management Improved management Market for corporate control – when acquisitions are used as tools for ousting underperforming managers Market for corporate control – when acquisitions are used as tools for ousting underperforming managers Ý many hostile takeovers are of this kind Synergy-motivated takeovers or mergers are usually friendly since the target firm’s managers have less reason to fear losing their position Synergy-motivated takeovers or mergers are usually friendly since the target firm’s managers have less reason to fear losing their position Bargain Price Bargain Price when shareholders place too low a value on a company’s shares a takeover may be profitable when shareholders place too low a value on a company’s shares a takeover may be profitable

Motives for Business Combinations Market power Market power Mergers lead to companies exercising market power, thereby controlling prices charged to consumers Mergers lead to companies exercising market power, thereby controlling prices charged to consumers Improved financing Improved financing A merger with an established firm opens project financing opportunities A merger with an established firm opens project financing opportunities Tax considerations Tax considerations Search for liquidity and management skills Search for liquidity and management skills Owners of private firms with no successor plan may be forced to sell out to obtain liquidity for retirement Owners of private firms with no successor plan may be forced to sell out to obtain liquidity for retirement

Motives for Business Combinations

Discounted Cash Flow Analysis The value an acquisition contributes to the acquiring firm is given by the NPV The value an acquisition contributes to the acquiring firm is given by the NPV NPV = present value of incremental net future cash flows that accrue because of the acquisition - the acquisition price - the acquisition price The discount rate to compute the NPV must reflect the risk inherent in that firm’s cash flows The discount rate to compute the NPV must reflect the risk inherent in that firm’s cash flows

Discounted Cash Flow Analysis Because businesses have an indefinite economic life, the selection of a proper time horizon is critical Because businesses have an indefinite economic life, the selection of a proper time horizon is critical Alternative approaches to time horizon include: Alternative approaches to time horizon include: 1. Choice of an arbitrary cut-off date 2. Estimation of cash flows for a number of years, with some assumptions regarding cash flows after that date 3. Projections of cash flows to a specified cut-off, followed by an assumed liquidation of the investment at that time with estimated fair market value

Discounted Cash Flow Analysis Firms that are liquid with unused debt capacity are attractive takeover targets because the acquisition can be financed by the target company’s own financing abilities after the takeover Firms that are liquid with unused debt capacity are attractive takeover targets because the acquisition can be financed by the target company’s own financing abilities after the takeover Leveraged buyouts – when the acquiring firm puts up a minimal amount of equity, using the expected cash flows and assets of the target company to obtain debt financing Leveraged buyouts – when the acquiring firm puts up a minimal amount of equity, using the expected cash flows and assets of the target company to obtain debt financing

Accounting for Business Combinations In Canada, surviving companies will account for an acquisition through the purchase method In Canada, surviving companies will account for an acquisition through the purchase method Purchase method – when the assets of the firm being acquired are revalued to reflect the purchase price and are integrated into the acquiring firm’s balance sheet at the revised value Purchase method – when the assets of the firm being acquired are revalued to reflect the purchase price and are integrated into the acquiring firm’s balance sheet at the revised value

Effects of Mergers on Earnings Per Share Most mergers have an immediate and major impact on reported earnings, which provides a strong misguided motive for some mergers Most mergers have an immediate and major impact on reported earnings, which provides a strong misguided motive for some mergers Phantasmic growth – when growth in EPS is achieved through mergers with firms having low P/E ratios Phantasmic growth – when growth in EPS is achieved through mergers with firms having low P/E ratios

Procedures Legal aspects Legal aspects The rules and regulations concerning business combinations are outlined in: The rules and regulations concerning business combinations are outlined in: Ý The Canadian Business Corporation Act Ý Stock exchange regulations The regulations provide shareholders the information and opportunity to participate in any final decision The regulations provide shareholders the information and opportunity to participate in any final decision The main federal issue looked at in mergers and acquisitions is competition policy The main federal issue looked at in mergers and acquisitions is competition policy

Procedures Friendly combinations Friendly combinations Business combinations occur through friendly negotiations between the management of the two corporations or through a takeover bid Business combinations occur through friendly negotiations between the management of the two corporations or through a takeover bid Major issues in the bargaining process include: Major issues in the bargaining process include: Ý price paid for the acquisition Ý synergies created by combining the companies

Procedures Tender offers Tender offers tender offer – the acquiring firm bypasses management and makes a direct offer to shareholders of the targeted company tender offer – the acquiring firm bypasses management and makes a direct offer to shareholders of the targeted company Management can fight unfriendly takeovers through: Management can fight unfriendly takeovers through: 1. legal barriers 2. poison pills 3. soliciting competing takeover bids from other firms 4. company changes making it less attractive to the acquiring firm 5. counter-attacks

Procedures Purchase of assets or shares Purchase of assets or shares l External expansion can be accomplished through: Ý purchasing another firms assets ã attractive when target has contingent liabilities Ý gaining a firm’s control by purchasing the company’s shares ã in this case, both assets and liabilities are taken over by the parent company

Public Policy Implications of Business Combinations Public concerns over past and future mergers include: Public concerns over past and future mergers include: corporate concentration and power corporate concentration and power declining competition declining competition foreign control and ownership foreign control and ownership large debt loads restricting new investments large debt loads restricting new investments

Summary 1. The combination of separate business entities in the form of mergers, amalgamations, and the use of holding companies can achieve business expansion externally for a firm. Ultimately, the driving force behind any expansion should be a creation of value that increases shareholder wealth.

Summary 2. An acquisition should only be pursued if it generates a positive net present value. Estimated future cash flows that accrue as a consequence of an acquisition should reflect any actions that the new management may implement, and the discount rate applied should be commensurate with the target firm’s perceived risk.

Summary 3. Business combinations affect reported earnings per share (EPS), the shares’ price- earnings (P/E) ratio, and market price of the surviving entity. EPS, however, may grow if one firm acquires another whose shares trade at a lower P/E ratio. 4. Net assets of the acquiring firms are revalued to reflect the purchase price actually paid, and incomes of the two businesses are pooled as of the date of acquisition.

Summary 5. A combination may be arranged through negotiations between management followed by shareholder ratification or through a tender offer. Reluctant management can pursue a variety of strategies to fend off an unfriendly takeover and to protect their own interests. 6. A variety of statutes dictate the rules under which a business combination may occur because of economic concerns and past abuses.