2. There are three basic legal procedures that
one firm can use to acquire another firm:
◦ Merger or Consolidation
◦ Acquisition of Stock
◦ Acquisition of Assets
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Merger
◦ One firm is acquired by another
◦ Acquiring firm retains name and acquired firm
ceases to exist
◦ Advantage – legally simple
◦ Disadvantage – must be approved by stockholders
of both firms
Consolidation
◦ Entirely new firm is created from combination of
existing firms
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A firm can be acquired by another firm or
individual(s) purchasing voting shares of the firm’s
stock
Tender offer – public offer to buy shares
Stock acquisition
◦ No stockholder vote required
◦ Can deal directly with stockholders, even if management is
unfriendly
◦ May be delayed if some target shareholders hold out for
more money – complete absorption requires a merger
Classifications
◦ Horizontal – both firms are in the same industry
◦ Vertical – firms are in different stages of the production
process
◦ Conglomerate – firms are unrelated
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3. Merger
Acquisition Acquisition of Stock
Takeovers Proxy Contest Acquisition of Assets
Going Private
(LBO)
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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 are not 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.
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Suppose firm A is contemplating acquiring firm
B.
The synergy from the acquisition is
Synergy = VAB – (VA + VB)
The synergy of an acquisition can be determined
from the standard discounted cash flow model:
T
CFt
Synergy = (1 + R)t
t=1
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4. Revenue Enhancement
Cost Reduction
◦ Replacement of ineffective managers
◦ Economy of scale or scope
Tax Gains
◦ Net operating losses
◦ Unused debt capacity
Incremental new investment required in
working capital and fixed assets
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Avoiding Mistakes
◦ Do not ignore market values
◦ Estimate only Incremental cash flows
◦ Use the correct discount rate
◦ Do not forget transactions costs
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Earnings Growth
◦ If there are no synergies or other benefits to
the merger, then the growth in EPS is just an
artifact of a larger firm and is not true growth
(i.e., 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.
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5. The Base Case
◦ If two all-equity firms merge, there is no transfer
of synergies to bondholders, but if…
Both Firms Have 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 and/or increase post-
merger debt usage.
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Typically, a firm would use NPV analysis when
making acquisitions.
The analysis is straightforward with a cash
offer, but it gets complicated when the
consideration is stock.
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The NPV of a cash acquisition is:
◦ NPV = (VB + ΔV) – cash cost = VB* – cash cost
Value of the combined firm is:
◦ VAB = VA + (VB* – cash cost)
Often, the entire NPV goes to the target firm.
Remember that a zero-NPV investment may
also be desirable.
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6. Value of combined firm
◦ VAB = VA + VB + V
Cost of acquisition
◦ Depends on the number of shares given to the
target stockholders
◦ Depends on the price of the combined firm’s
stock after the merger
Considerations when choosing between
cash and stock
◦ Sharing gains – target stockholders do not
participate in stock price appreciation with a
cash acquisition
◦ Taxes – cash acquisitions are generally taxable
◦ Control – cash acquisitions do not dilute control
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In a friendly merger, both companies’
management are receptive.
In a hostile merger, the acquiring firm
attempts to gain control of the target without
their approval.
Tender offer
Proxy fight
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Corporate charter
◦ Classified board (i.e., staggered elections)
◦ Supermajority voting requirement
Golden parachutes
Targeted repurchase (a.k.a. greenmail)
Standstill agreements
Poison pills (share rights plans)
Leveraged buyouts
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7. Poison put
Crown jewel
White knight
Lockup
Shark repellent
Bear hug
Fair price provision
Dual class capitalization
Countertender offer
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Shareholders of target companies tend to
earn excess returns in a merger:
◦ Shareholders of target companies gain more in a
tender offer than in a straight merger.
◦ Target firm managers have a tendency to oppose
mergers, thus driving up the tender price.
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Shareholders of bidding firms earn a small
excess return in a tender offer, but none in
a straight merger:
◦ Anticipated gains from mergers may not be
achieved.
◦ Bidding firms are generally larger, so it takes a
larger dollar gain to get the same percentage
gain.
◦ Management may not be acting in stockholders’
best interest.
◦ Takeover market may be competitive.
◦ Announcement may not contain new information
about the bidding firm.
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8. 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.
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The Purchase Method
◦ Assets of the acquired firm are reported at their fair
market value.
◦ Any excess payment above the fair market value is
reported as “goodwill.”
◦ Historically, goodwill was amortized. Now it
remains on the books until it is deemed “impaired.”
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The existing management buys the firm from
the shareholders and takes it private.
If it is financed with a lot of debt, it is a
leveraged buyout (LBO).
The extra debt provides a tax deduction for
the new owners, while at the same time
turning the pervious managers into owners.
This reduces the agency costs of equity.
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9. Divestiture – company sells a piece of itself to
another company
Equity carve-out – company creates a new
company out of a subsidiary and then sells a
minority interest to the public through an IPO
Spin-off – company creates a new company
out of a subsidiary and distributes the shares
of the new company to the parent company’s
stockholders
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What are the different methods for
achieving a takeover?
How do we account for acquisitions?
What are some of the reasons cited for
mergers? Which of these may be in
stockholders’ best interest and which
generally are not?
What are some of the defensive tactics that
firms use to thwart takeovers?
How can a firm restructure itself? How do
these methods differ in terms of ownership?
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