Chapter 22: Mergers and Corporate control Flashcards
Holding company
a form of corporate control in which one corporation controls other companies by owning some or all of their stocks
Primary motivation for most mergers
To increase the value of the combined enterprise
Synergy
Occurs when the whole is greater than the sum of its parts.
Synergistic merger
when the post merger earnings exceed the sum of the separate companies’ pre-merger earnings
Sources of synergistic effects
- operating economies (economies of sale)
- differential efficiency (more efficient firm’s management will increase overall efficiency after merger)
- financial economies
- tax effects
- increased market power (reduced competition)
Financial economies
- decreased borrowing costs
- decreased transaction/ issuing costs
- improved coverage from security analysts
Oligopoly
when several firms dominate an industry and choose not to compete on the basis of prices
firms as a group behaving like a monopoly
Why might a profitable company want to acquire a firm with low or even negative income
if firm to be acquired has large accumulated tax losses those losses may be used to offset the acquiring firm’s taxable income
(congress has limited the use of loss carryforwards in mergers specifically to limit this practice)
alternately may be able to use that firm’s carried-over interest expenses
Why use excess free cash flow to acquire another company rather than pay dividends or repurchase stock?
If pays dividends, stockholders must pay tax on those dividends
if repurchase stock the selling shareholders must pay capital gains taxes, acquisition avoids these tax consequences
Per the book this is not a good reason to acquire another entity
Breakup value
a firm’s value if it’s assets are sold off in pieces
if higher than combined value may be motivation for certain specialists to acquire the company in order to sell off the pieces for a profit
Diversification as a motive for mergers
debatable. May help stabilize earnings but there is researching showing that diversified conglomerates are worth less than the sum of their individual parts
may work for the owner-manager of a closely held firm, for whom acquisition may be less difficult than selling closely-held stock
Types of mergers based on the business of the acquirer and target
- horizontal
- vertical
- congeneric
- conglomerate
horizontal merger
one firm combines with another in the same line of business
Roll-up merger
Type of horizontal merger where a firm purchases many small companies in the same industry and “rolls them up” to create a consolidated brand
Vertical merger
Merger where one company’s products are used by the other company (merger of upward or downward sections of the supply chain)
Congeneric Merger
“allied in nature or action”
Merger of related enterprises that are not producers of the same product (horizontal) or in a producer-supplier relationship (vertical)
Conglomerate merger
merger of unrelated enterprises
Primary purchase methods for mergers and acquisitions
1) stock offerings to provide target shareholders with stock in the acquirer’s post-merger company in exchange for their snares
2) cash offers to purchase assets
3) cash offers to purchase shares
hidden liabilities
liabilities that are unknown by the acquirer at the time of acquisition
may become responsibility of acquirer without prior knowledge if acquire target shareholders’ stock
Due diligence
the detailed investigation of a target of a potential acquisition, including financial statements, legal liabilties, etc…
cash purchase of assets
acquirer not generally responsible for hidden liabilities since they and the target specify which assets go to the acquirer
Types of hidden liabilities
- unforeseen by both acquirer and target (product liabilities)
- known by target’s senior managers but hidden from the acquirer
- known but grossly underestimated at the time of the merger
Merger waves
the empirical observation that mergers tend to cluster in time, becoming frequent in some years and infrequent in others
Historical merger waves
- 1900s (horizontal mergers create monopolies)
- 1920s (mergers consolidate industries and integrate supply chains)
- 1960s (creation of conglomerates)
- 1980s (hostile takeovers and congeneric mergers)
- 1990s (deregulation leads to mergers of once-sheltered industries)
steps of a merger once a target has been identified
1) establish a suitable price or price range
2) decide on payment terms
3) decide how to approach company management
to tender shares (in case of a merger)
When stockholders of a merger target turn over their shares to a designated financial institution, along with a signed power of attorney that transfers ownership of the shares to the acquiring firm
Friendly merger
when the target company’s management agrees to the merger and recommends that the shareholders approve the deal
hostile merger
Occurs when the management of the target company resists the offer from the acquiring company. Acquiring company bypasses the management of the target company and makes an offer directly to the company’s shareholders
tender offer
the offer of one firm to buy the stock of another by going directly to the stockholders, frequently over the opposition of the target company’s management
Takeover defenses
- staggered terms for directors (not all directors elected at one time so boards cannot be changed over all at once)
- requiring a super majority (75%) to approve any mergers
- raise potential antitrust issues to the justice department
- appeal to another company to acquire the target firm first
- poison pill defense
- golden parachutes
- greenmail
white knight
a friendly competing bidder that a target management likes better than the company making a hostile offer. Target solicits a merger with the white night as a preferable alternative
Defensive merger
occurs when the management of an acquisition target under threat of hostile takeover seek out a friendly company to acquire their company
White squire
an investor who is friendly to current management and can buy enough of the target firm’s shares to block a merger/ hostile takeover
golden parachute
a large payment to executives who are forced out when a merger takes place
Poison pill defense
shareholder rights provision allowing existing shareholders in the target to purchase additional shares of stock at a lower-than-market value if a potential acquirer purchases a controlling stake
Greenmail
when the target buys back stock from the acquirer at a higher than market price in return for the acquirer agreeing to cease acquisition attempts for a specified number of years
Requirements of the 1968 Williams Act
- acquirers must disclose current holdings and future intentions within 10 days of amassing 5% or more of a company’s stock
- acquirers must disclose the source of the funds to be used in acquisition
- target firm’s shareholders must be allowed at least 20 days to tender their shares (offer must be open for 20 days)
- if acquiring firm increases the offer price during the 20-day open period then all shareholders who tendered prior to the new offer must receive the higher price
Control share acquisition statutes
state statutes intended to limit voting power (if raider purchases enough stoke to be able to impact the vote regarding the takeover)
Business combination statutes
state statutes that come into effect if a minority shareholder (such as a raider) owns more than a specified percentage of voting shares
may forbid raider from acquiring target for some given period
Expanded constituency statutes
state statutes that expressly permit the board to consider stakeholders other than just shareholders (ex: employees)
Assumption of Labor contract laws
state laws mandating that hostile acquirers continue to honor existing labor contracts
Fair price provisions
state statutes that require a raider to pay the same price in a two-tier tender offer instead of a higher price in the first tier and a lower price in the second
Face price bylaws
Company bylaws requiring that any merger bid must meet or exceed a price that is determined by market conditions (ex: industry price/equity ration)
Control share cash-out statute
if a company or investor acquires enough stock of another company to exceed the state’s control threshold the target’s remaining shareholders can require the purchaser to buy their shares at fair price (even if purchaser did not intend to immediately attempt acquisition)
discourages investors from gaining large minority interest without plans to acquire the company
may actually stimulate the occurance of hostel mergers
State laws protecting shareholders from company management
Put limits on use of golden parachutes, poison pills, greenmail
Revlon Rule
requirement adopted by 10 states (specifically rejected by others) that if there are multiple company’s bidding for a target, the target must accept the bid with the highest price
questions for the acquiring firm before a merger
- how much would the target be worth after being incorporated into the acquirer? (not the same as current value)
- how much should the acquirer offer the target?
Two basis approaches for merger valuation
Discounted Cash Flow techniques (DCF. most commonly used)
Market multiple analysis
Widely used Discounted Cash Flow valuation methods
- free cash flow corporate valuation method
- compressed adjusted present value method
(AKA Compressed AVP. Only appropriate model if there is a nonconstant capital structure during the explicit forecast period) - free cash flow to equity method (aka equity residual method)
capital structure
Percent of debt vs equity used to finance a company
Capital Asset Pricing Model
Required rate of return on equity = risk free rate + (beta of company * market risk premium)
Weighted average cost of capital
WACC = (% of debt * pretax cost of debt * (1-tax rate)) + (% of equity * Required rate of return on equity from CAPM model)
Financial merger
a merger in which companies will not be operated as a single unit and for which no operating economies are expected (and no operating synergies expected)
Post merger cash flows for financial merger
target firm’s expected cash flows
Operating merger
When the operations of two companies are integrated with the expectation of obtaining synergistic gains. This may occur in response to economies of scale, management efficiency, or other factors.
Post-merger cash flows from operating merger
must estimate affect of expected synergies
unlevered cost of equity
cost of equity if company had no debt
= (% equity * required rate of return on equity) + (% debt * cost of debt)
unlevered beta
= (cost of debt - risk free rate)/ Market premium
(can then be used in CAPM to find unlevered cost of equity)
Horizon value of unlevered cash flows
uses constant growth formula
= (FCF previous year * (1+growth rate)) / (unlevered cost of equity - growth rate)
Horizon value of tax shield
= (tax shield for previous year * (1+ growth rate) / (unlevered cost of equity - growth rate)
unlevered value of operations
Present value of the free cash flows during the horizon period and the horizon value of the free cash flows
all discounted using unlevered cost of equity
Total value of operations
= unlevered value of operations+ horizon value of tax shield
Value of equity
= total value of operations - value of debt
aka maximum amount acquiring company should pay for target stock (if pay more, dilute their own value)
Synergistic benefits
the difference between the value of a company to an acquirer (which reflects synergy) and the value to the target if not acquired (market equity)
greater synergistic benefits = greater gap between target’s current market price and the max the acquiring company is wiling to pay
When would the acquirer have the bargaining power?
If the acquirer had multiple potential targets with which it could gain synergies, but the target had no options for synergies but the acquirer
When would the target have the bargaining power?
- if they have some unique technology or other unique way of creating synergy that has value to multiple potential acquirers
Cash offers
Maximum price per share acquirer is willing to pay will be value of equity (with synergies) / # of shares
but cash offers have tax consequences that stock offers do not
Stock offers
shares of target company exchanged for new shares of the post-merger company
stock offered that is worth the same value as the cash that would be offered
since acquirers’ original stockholders now must share ownership with target stockholders their ownership percentage goes down, but assuming the post-merger synergies are realized the combined intrinsic value of the company should increase over the simple combined original values so everyone gains
to determine stock offer quantity/ exchange ration for stock
solve for N(new) (number of new shares)
Percent required by target stockholders = (N(new))/ (N(new)+N(old))
exchange ratio = shares of new stock/ shares of target stock
how to determine what change in market value of stock can be attributed to reaction to a merger (or other) announcement vs normal market movement
Must separate portion of return due to market conditions by calculating the expected return for bidder and target on the day of the announcement using CAPM or other models
Actual return - expected return = abnormal return, aka reaction to announcement
average abnormal stock returns for target firms after merger announcement
30%: hostile tender offer
20%: friendly merger
vs 0 for acquiring firm indicates that average acquisition creates value from which the target firm’s shareholders predominantly benefit
Average abnormal return for acquiring firm after merger announcement
approximately 0 no matter what
Change in percentage of hostile mergers after williams act
Went from 40% of mergers being hostile to 9%
takeover index
measures a company’s susceptibility to a hostile takeover bid
generally (all else held equal) the value of a firm’s stock is lower if the firm is less susceptible to a takeover
executives not worried about hostile takeover –> shareholders suffer (stock less valuable and remains so)
Role of investment bankers in mergers
- help arrange mergers
- help target companies develop and implement defensive tactics
- help value target companies (because if price is too low or too high one side or the other’s shareholders might sue)
- help finance mergers
- invest in the stocks of potential merger candidates
How investment bankers help arrange mergers?
identify:
- companies with excess cash that might want to buy other firms
- companies that might be willing to be bought
- firms that might be a good acquisition target
How would overpricing a target for a merger hurt an investment bank
- bank is less likely to be retained as an advisor if past acquirers consistently had poor abnormal announcement returns (indicating overpriced offer)
- if investment bank is publicly traded, a positive return for investment bank’s client (the acquirer) tends to result in a positive return for the bank (and also the opposite)
risk arbitrage
the practice of purchasing stock in companies (in the context of mergers) that may become takeover targets, in the hope of profiting when the takeover drives up the target’s stock price
often done by brokerage houses
Merger of equals
a consolidation of two companies of approximately the same size where shareholders and executives of both companies have approximately the same amount of control in the post-merger company
Holding companies
Corporations formed for the sole purpose of owning the stocks in other corporations. Holding company becomes parent company to its held subsidiaries (aka operating companies)
Advantages of a holding company over an operating company with multiple divisions
- can control other companies through fractional ownership (owning enough to have working control of operations via the highest percentage of stock)
- isolation of risk (other companies owned by the holding company are protected from any legal claims against any one operating company - isolation may be pierced if parent guarantee’s the subsidiary’s debt)
Disadvantage of a holding company
partial multiple taxation of dividends
holding company shareholders taxed on dividends received from the holding company who may have already been taxed on dividends received from the operating companies.
tax on dividends of partially owned subsidiaries
Holding company owns < 20% of operating: may deduct 70% of the dividends received (taxed on 30%)
Holding company holds over 20% but less than 80%: may deduct 80% of the dividends received
Holding company owns 80%+ of subsidiary’s voting stock: file consolidated returns ergo dividends received by parent from subsidiary not taxed
Debt ratios and holding companies
the debt ratio of the individual company is not the true debt ratio of the holding company, which must consider it’s percentage ownership of debt and equity (consider how it would look when consolidated - investments in subsidiary’s go away)
Strategic Alliances
aka corporate alliances
a cooperative deal that stops short of a merger but still allows firms to create combinations that focus on specific business lines that offer the most potential synergies
everything from marketing agreements to joint ventures
Joint venture
corporate alliance in which parts of separate companies are joined together to accomplish specific, limited objectives.
controlled by the combined management of the parent companies
tends to result in favorable market reaction and improved operating performance
Divestiture
Opposite of an acquisition. When a company sells a portion of its assets - often a whole division - to another firm or individual
Types:
- sale of assets to another firm (purchased as a whole for stock or cash)
- liquidation (assets sold off piecemeal
- spin-off
- equity carve out
Spin-off
Firm’s existing stockholders are given new stock representing separate ownership rights in the division that was divested
division establishes own board and officers and becomes a second company. so stockholders end up with shares in two companies
Equity carve-out
a minority interest in a corporate subsidiary is sold to new shareholders (parent gains new equity financing and retains control)
Market reaction to divestitures
generally favorable - small stock price increase on day of the announcement. also generally improve operating performance for both parent and divested companies
nontaxable exchange of stock
a stock offering to provide target shareholders with stock in the acquirer’s post-merger company in exchange for their shares
shareholders pay no tax at the time of the merger as long as offer is MOSTLY stock (even if there is some amount of cash mixed in, also long as it is not significantly cash or bonds)
basis of new stock is the basis of the shareholder’s original stock
both delays taxation and provides opportunity to benefit from synergy of merger
potentially only small depreciation tax shield
Taxable purchase of assets
a cash offer to purchase almost of all of the assets of the target
target pays tax on any gain on sale of assets
shareholders pay tax on any distribution of residual gains (including possible addition net investment income tax)
taxable purchase of shares
cash offer to purchase shares from target’s stockholders, either directly to shareholders (hostile takeover), or to board of directors (friendly merger)
sometimes target retains separate legal identity and operates as subsidiary. other times dissolved and operated as division of acquiring firm
acquirer can choose to record target assets at book or appraised value
Process of a cash purchase of target’s assets
1) board votes to recommend if shareholders accept or reject offer (vote is not binding on shareholders)
2) shareholders accept = payment goes directly to target corp and pays off any debt not assumed by acquiring firm + pays tax on gain from sale, the distributes remaining to shareholders (perhaps in liquidating dividend)
3) target dissolved as separate entity and continues as division or wholly owned subsidiary of acquiring firm
effective tax rate to shareholders in taxable purchase of assets
total tax to selling corporation+ to shareholders / total income
Tax benefits for taxable purchase of assets
Newly acquired assets added to books and depreciated as if it is new property (including bonus depreciation where applicable). not required to continue using target’s existing depreciation schedule. Any goodwill is amortized and reduces future taxable income
Taxable purchase of shares: assets recorded at book value
means assets continue to be depreciated at depreciation schedule from target. no goodwill as deductible expense. minimal tax deductions to acquirer
Taxable purchase of shares: assets recorded at appraised values
- target incurs tax liability for difference between appraised and book value, which acquiring firm is responsible for paying after acquisition
- acquiring firm can then take bonus depreciation on appraised value of assets and deduct any goodwill amortization (potential higher tax deductions for acquirer)
accounting method for mergers
purchase accounting
purchase accounting
a method of accounting for a merger in which the merger is handled as a purchase. In this method, the acquiring firm is assumed to have “bought” the acquired company in much the same way it would buy a capital asset
Purchase accounting if price paid exceeds net asset value of target
asset values will be increased to reflect price actually paid
Purchase accounting if price paid is less than net asset value of target
asset values must be written down when preparing the consolidated balance sheet
Depreciation after merger
If assets had to be revalued then depreciation expense for year changes going forward (which will impact the income statement)
