Corporate Finance - Chp. 26: Mergers and Acquisitions

Question 1

• Forms of integration

Answer 1

• Statutory merger – acquiring company gets all of target’s assets and liabilities and it ceases to exist
• Subsidiary merger – target company becomes subsidiary of purchaser
• Consolidation – both companies cease to exist and become totally new company

Question 2

• Types of mergers

Answer 2

• Horizontal merger – two companies operate in same business
• Vertical merger – acquitting company seeks to move up or down the supply chain
  
  • Forward integration – moves towards the customer
  • Backward integration – moves towards raw materials
• Conglomerate merger - two companies operate in totally separate industries

Question 3

• Motives for mergers

Answer 3

• Synergies – combined company worth more than the two separate
  
  • Usually reduced costs or increased revenues
• Achieving more rapid growth – faster growth than making investments internally
• Increased market power
• Gaining access to unique capabilities
• Diversification
• Bootstrapping EPS
• Personal benefits for managers
• Tax benefits
• Unlocking hidden value
• Achieving international business goals

Question 4

• Bootstrapping

Answer 4

• High P/E firm acquires low P/E firm
• When computing EPS, the earnings of the two firms are added, but the total shares is less than the sum

Question 5

• Pioneer/development phase

Answer 5

• Younger companies marketing themselves to more mature
• Conglomerate mergers or horizontal mergers

Question 6

• Rapid growth phase

Answer 6

• Driven by more capital resources to finance expansion
• Conglomerates and horizontal mergers

Question 7

• Mature growth phase

Answer 7

• Reduced industry profits but still growth
• Horizontal and vertical mergers

Question 8

• Stabilization phase

Answer 8

• Not much growth
• Horizontal mergers

Question 9

• Decline phase

Answer 9

• Declining profits
• All three types

Question 10

• Forms of acquisitions

Answer 10

• Stock purchase
  
  • Shareholders receive the compensation so must approve
  • Shareholders bear any tax consequences
  • Must purchase entire company
• Asset purchase
  
  • If assets are less than 50% shareholders vote not required
  • Target company pays the capital gains tax
  • Acquirer usually avoids targets liabilities

Question 11

• Method of payment

Answer 11

• Securities offering
  
  • Shareholders receive acquirers stock in exchange for their shares of target
  • Based on exchange ratio, number of shares of target company outstanding, an value of acquirers stock
• Cash offerings
• Factors
  
  • Distribution of risk and reward for acquirer and target shareholders
  • Relative valuations of companies involved (if acquirers shares are overvalued)
  • Changes in capital structure – if acquirer must take on debt for payment

Question 12

• Attitude of target management

Answer 12

• Friendly merger offers
  
  • Definitive merger agreement signed before announced to public
• Hostile merger offers
  
  • Bear hug – proposal submitted directly to targets board
  • If bear hug unsuccessful, next step is to go to shareholders
    
    • Tender offer – acquirer offers to buy shares direct from shareholders and each either accepts or rejects
    • Proxy battle – seeks to have shareholders vote in “acquirer approved”” board

Question 13

• Pre-offer defense mechanisms

Answer 13

• Poison pill – gives current shareholders the option to purchase stock at below market price, causing dilution and effectively increases cost to potential acquirer
  
  • triggered when a shareholder’s equity stake exceeds 10%
  • flip in – targets shareholders have right to buy target’s shares at discount
  • flip-over – target’s shareholders have the right to buy acquirers shares at discount
• Poison put – allows bondholders to demand immediate repayment of their bonds if there is hostile takeover. Would put additional cash burden on acquirer
• Staggered board – would make taking over a board take longer
• Restricted voting rights – equity ownership above some threshold triggers loss of voting rights
• Supermajority voting provision for mergers
• Fair price amendment
• Golden parachutes

Question 14

• Post offer defense mechanisms

Answer 14

• Just say no defense
• Litigation – attack merger on antitrust grounds
• Greenmail – payoff of potential acquirer
• Share repurchase – target submits tender offer for its own shares
• Leveraged recapitalization – target assumes large amount of debt used to finance share repurchases. Changes capital structure to make target less attractive
• Crown jewel defense – sell a major asset to neutral third party
• Pac man defense – target tries to takeover acquirer
• White knight defense – third party comes in with higher price
• White squire defense – buys a minority stake in target

Question 15

• Herfindahl-Hirschman Index – measure of market power for determining antitrust violations

Answer 15

• HHI = n∑i = 1(MSi×100)²
• MS_i = market share of firm i
• n = number of firms in the industry
• if <1000, antitrust challenge unlikely
• if 1000-1800, moderately competitive industry, if HHI is changing by >100 points in merger challenge is likely
• if >1800, regulators will challenge if change >50 points due to merger

Question 16

Discounted cash flow analysis

Answer 16

• Advantages
  
  • Easy to model changes is company’s cash flows occurring from the merger
  • Based on forecast of future conditions rather than current data
  • Easy to customize
• Disadvantages
  
  • Difficult when cash flows are negative
  • Estimates of cash flows and earnings are highly subject to error
  • Discount rate changes over time can have a large impact on the valuation estimate
  • Estimation error is a major concern since the majority of the estimated value for the target is based on the terminal value

Question 17

Comparable company analysis

Answer 17

• Advantages
  
  • Data for comparable companies is easy to access
  • Assumption that similar assets should have similar values is fundamentally sound
  • Estimates of value are derived directly from the market rather than assumptions and estimates about the future
• Disadvantages
  
  • Approach implicitly assumes that the market’s valuation of the comparable companies is accurate.
  • Using comparable companies provides an estimate of a fair stock price, but not a fair takeover price. An appropriate takeover premium must be determined separately
  • It is difficult to incorporate merger synergies or changing capital structures into the analysis
  • Historical data used to estimate a takeover premium may not be timely, and therefore may not reflect current conditions in the M&A market

Question 18

Comparable transaction analysis

Answer 18

• Advantages
  
  • Since the approach uses data from actual transactions, there is no need to estimate a separate takeover premium.
  • Estimates of value are derived directly from recent prices for actual deals completed in the marketplace rather than from assumptions and estimates about the future
  • Use of prices established by recent transactions reduces the risk that the target’s shareholders could file a lawsuit against the target’s managers and board of directors for mispricing the deal
• Disadvantages
  
  • The approach implicitly assumes that the M&A market valued past transactions accurately
  • There may not be enough comparable transactions to develop a reliable data set
  • It is difficult to incorporate merger synergies or changing capital structures into the analysis

Question 19

• Post-merger value of an acquirer

Answer 19

• V_AT = V_A + V_T + S – C
  
  • V_AT= post-merger value of the combined company (acquirer + target)
  • V_A = pre-merger value of acquirer
  • V_T = pre-merger value of target
  • S = synergies created by the merger
  • C = cash paid to target shareholder

Question 20

• Gains accrued to the target

Answer 20

• the takeover premium is the amount of compensation received in excess of the pre-merger value of the target’s shares
• Gain_T = TP = P_T – V_T
  
  • Gain_T = gains accrued to target shareholders
  • TP = takeover premium
  • P_T = price paid for target
  • V_T = pre-merger value of target

Question 21

• Gains Accrued to the Acquirer

Answer 21

• Acquirers are willing to pay a takeover premium because they expect to generate their own gains from any synergies created by the transaction. The acquirer’s gain is therefore equal to the synergies received less the premium paid to the target’s shareholder
• Gain_A = S – TP = S – (P_T – V_T)

Question 22

• Cash Payment Versus Stock Payment

Answer 22

• With a cash offer, the target firm’s shareholders will profit by the amount paid over its current share price (i.e., the takeover premium). However, this gain is capped at that amount.
• for a stock deal we must adjust our formula for the price of the target:
• P_T = (N × P_AT)
  
  • N = number of new shares the target receives
  • P_AT = price per share of combined firm after the merger announcement

Question 23

• Effect of payment method

Answer 23

• Cash offer – acquirer assumes risk/reward from synergies created, target shareholders upside limited to takeover premium
• Stock offer – some risk/reward shifts to target firm

Question 24

Characteristics of positive return deals

Answer 24

• Strong buyer
• Low premium
• Few bidders
• Favorable market reaction

Question 25

Divestitures

Answer 25

selling, liquidating, or spinning off a division or subsidiary

Question 26

Equity carve-outs

Answer 26

create a new, independent company by giving an equity interest in a subsidiary to outside shareholder through IPO

Question 27

Spin-offs

Answer 27

like carve-outs in that they create a new company that is distinct from the parent company. Not IPO’d though, but distributed proportionately to the parent company’s shareholders

Question 28

Split-offs

Answer 28

allow shareholders to receive new shares of a division of the parent company in exchange for a portion of their shares in the parent company. The key here is that shareholders are giving up a portion of their ownership in the parent company to receive the new shares of stock in the division.

Question 29

Liquidations

Answer 29

break up the firm and sell its asset piece by piece. Most liquidations are associated with bankruptcy

Question 30

• Reasons for restructuring

Answer 30

• Division no longer fits long term strategy
• Lack of profitability
• Individual parts are worth more than the whole
• Infusion of cash