Lecture 8b: Takeovers 2 Flashcards
1.) Economic Rationale for Takeovers 2.) Empirical Evidences of Takeovers
What are the 9 Economical Reasons for Takeovers (ACRONYM(
MU UCPD FT. EPS
TAKEOVER REASON 1: M
Management of Target Company is inefficient
What is the evidence to support the inefficient management of the target company? Breakdown the Trend
On average, target companies underperform months before the announcement (underperform with a negative cumulative abnormal return)
Few days before announcement, cumulative abnormal return goes up to 12%, because of disclosure and insider trading
On announcement date, share price goes up by about 10% to 24% and STAYS CONSTANT.
TAKEOVER REASON 2 : C
Complementary Assets
Elaborate on TAKEOVER REASON 1 (M)
MANAGEMENT
Takeover replaces managers who are inefficient and too self-interested
Having a more efficient management can increase the value of the firm
Elaborate on TAKEOVER REASON 2 (C)
COMPLEMENTARY ASSETS
Horizontal/Vertical - Takeovers attractive if companies can provide others with needed assets at relatively low costs (Economies of Scale)
Conglomerate - Taking over small companies who cannot realize their full potential because their managers do not have skills across all areas of management (asset + management)
Is the argument “complementary assets’ applicable to human resources
Yes. For examples, if T has engineers, B (bigger firm) might want to takeover to use them
TAKEOVER REASON 3: U
Target Company is Undervalued
Elaborate on TAKEOVER REASON 3 (U)
UNDERVALUATION
Not NECESSARILY in the sense that target company is undervalued in the stock market. Undervalued to the BIDDER.
Investors/Managers identify better value from using company’s assets ALTERNATIVELY (!)
TAKEOVER REASON 4: C
Cost Reductions
Elaborate on TAKEOVER REASON 4 (C)
COST REDUCTIONS
- Total operating cost of BT < Operating cost B + Operating Cost T
Horizontal: Economies of Scale
Vertical: Cost savings from coordinating activities, improved communications, reduced bargaining cost,
etc
TAKEOVER REASON 5: P
Increase market power
Elaborate on TAKEOVER REASON 5 (P) - Controversial
INCREASE MARKET POWER (i.e. monopolize)
- Potential for increase dependent on whether there are significant barriers to entry
E.g. ACCC/other jurisdictions prohibits mergers likely to have the effect of substantially lessening competition
TAKEOVER REASON 6: D
Diversification
Elaborate on TAKEOVER REASON 6 (D).
Perspective of SH, DH
DIVERSIFICATION
- SH: No difference. They can diversify themselves (with a. own risk preference, and b. control premium)
- DH: Co-insurance effect. 2 companies whose earning streams less than perfectly correlated reduces default risk. If no economic benefit DH + SH - .
Main point: Equity holders do not gain/worse off by diversification
TAKEOVER REASON 7: F
Excess Free Cash Flow
Elaborate on TAKEOVER REASON 7 (F)
EXCESS FREE CASH FLOW
- Managers might prioritize acquisition over returning excess cash to shareholders (buyback/dividend)
- Conflict of interest between shareholders and managers may lead to little value/negative NPV takeovers
TAKEOVER REASON 8: T
Tax Benefits
Elaborate on TAKEOVER REASON 8 (T).
Tests to satisfy
TAX BENEFITS
If target company has accumulated tax losses, reduces total tax payable by combined company
Continuity-of-Ownership-And-Control = Owners >50% of shares in target company when it incurred losses remains as owners (Hard to pass)
Same-Business Test = Same line of business
Takeover of foreign company can shift company from high to low tax environment
Which taxation systems does taxes favor in takeover reason 8 (T)
Classical: Tc + Tp. Lowering Tc is good
Imputation: Tp. No benefits (assuming fully franked)
TAKEOVER REASON 9: EPS (Controversial)
Increase EPS and P/E Ratio Effects
Elaborate on TAKEOVER REASON 9 (EPS).
IINCREASE EPS AND P/E EFFECT
-By itself, an invalid argument: Can increase EPS without creating value
Bootstrapping: Whenever P/E of Bidding is higher than P/E of Target, EPS Increases and P/E Decreases if value remains constant.
Empirical Evidence of Takeovers 1: Do takeover comes in waves
Yes. Takeovers are positively correlated with behavior of share prices.
Empirical Evidence of Takeovers Wave: Why are there waves
Increase real demand = Increase Equity Returns = Increase productive capacity
As business and consumer confidence increases, takeover increases
What is productive capacity in takeovers
Productive efficiency of a firm - Internally (Debt/Equity) or External (TAKEOVERS).
Takeovers are quick way to expand.
Empirical Evidence of Takeovers 2: Motivation of Takeovers
- ) Synergy (37.3%)
- ) Diversification (29.3%)
Minor points (<10%): Achieve a specific organisational form (10.7%); Acquire target company below replacement cost; Free cash flow; Taxes; Others
Empirical Evidence of Takeovers 3: Sources of Synergy
- ) Operating Economies/Economies of Scale (89.9%)
- ) Transaction Cost (5.8%)
- ) Market Power (4.3%)
Empirical Evidence of Takeovers 4: Diversification
Perspective of people who agree
- ) Less devastation in economic downturn (50%)
- ) Take advantage of seasonality in production cycle (13.9%)
- ).) Internal capital allocation (12.5%)
Others
Empirical Evidence of Takeovers 5a: Target Company Performance Takeover. Before, Around, After
BEFORE announcement = Under performance
AROUND announcement (even in unsuccessful takeovers) = Significant abnormal positive return
AFTER takeover = significant abnormal positive return stays constant
Empirical Evidence of Takeovers 5b: Bidding Company Performance Takeover. Before, Around, After
YEARS BEFORE announcement = Significant abnormal positive returns (i.e. companies doing well)
AROUND announcement = average abnormal return is 0 or negative
POST-MERGER (3 years) = returns are on average negative
Who often wins from a takeover
Target company
Which method of payment is better (cash/stock) for target and bidding companies
Cash > Stock for both.
Stock can signal overvaluation.
Empirical Evidence of Takeovers 5b: Bidding Company poor performance reason 1 (W)
Wealth effects are disguised
Usually, value of bidding»_space;> value of target (gain is small relative to combined company)
Main Point: Bidding company known for acquisition. Announcement does not signal new info.
Announcement may be negative signal (esp in share exchange signals shares are overvalued)
Empirical Evidence of Takeovers 5b: Bidding Company poor performance reason 2 (C) and 2 sub reasons
Competition depresses returns
1.) Many bidders to 1 target = Target SH returns increases; Bidding SH returns decreases
1 Bidder to 1 Target/ No Competition = Bidding SH Returns increases
2.) Competition may be influenced by regulations (biased to targets)
Empirical Evidence of Takeovers 5b: Bidding Company poor performance reason 3 (P)
Takeovers are simply neutral/poor arguments and managements do it for ego.
What kind of takeover is reason 1 most applicable to, and why?
Horizontal takeovers - because bidding company managers have the expertise to manage target company operations more efficiently
Does inefficient management mean that management is inefficient?
Not necessarily, could be that management are acting in own interest rather than their ability.
What is Economies of Scale
Splitting of cost over wider base
Empirical Evidence of Takeovers 4: Diversification
Perspective of people who disagree
- ) Shareholders can diversify themselves (35.7%)
- ) Parents lose focus of company (31%)
- ) Firm should stay in business he knows (26.2%)
Linked with Diversification Discount
Why is cash better than stock as a method of payment
The market responds negatively to stock.
Takeover activity tends to vary significantly over time.
Outline the factors that may explain this variation.
- ) Share price levels (Share prices reflect an optimistic outlook for investments, some of which will be external)
- ) Economic shocks that affect particular industries, and are often followed by industry re-structuring
- ) Legislation (changes in legislative controls and foreign investment regulations)
Company can reduce risk by taking over
Do you agree with this statement? Is it a justifiable reason for a takeover
- Yes, but systematic risk of the combined company = average of the systematic risks of the two individual companies.
Investors can diversity themselves - takeover does not offer risk-reduction benefits that were not previously available to investors.
However, may be of value if there are barriers that prevent shareholders from directly diversifying.
A company with accumulated tax losses is necessarily a valuable takeover proposition. Discuss this
statement and give a caveat.
Only if provided that the acquiring company can use the tax losses (Same line of business/ continuity of ownership)
However, benefits associated with reducing company tax by using accumulated tax losses are likely to be small under the imputation tax system.
First, it provides diversification. Takeover statement tutorial question
- Diversification = Not sound reason for takeover (Can diversity in own portfolio)
- Nothing wrong with diversification provided that the investment is profitable in its own right. In this case, there is no evidence that Budget is at all attractive as an investment.
Second, he argues that by injecting fresh capital, Budget can be ‘rescued’ and should appreciate markedly in value. Budget works old computers.
- Takeover of Budget might be profitable if its problems were due to, say, inefficient management that could be replaced.
- However in the qs, its problems flow from fundamental characteristics of the computer industry. Injecting more funds may not be beneficial.
There is no reason for on acquiring company to prefer a cash bid to a stock exchange or vice versa.
Discuss this statement.
Cash bid = Fixed net cost is fixed
Share swap = Net cost depends on the gain associated with the takeover and on the distribution of the gain between the two companies’ shareholders (depends on bidding company’s shares after it has been announced)
Other factors include:
(a) Availability of Cash
(b) Dilution of ownership and control for existing SHs
(c) Effect on the company’s capital structure. For example, loan covenants or trust deed provisions may restrict the raising of cash by borrowing.
What are the benefits and costs associated with having the Australian Competition and Consumer
Commission (ACCC) involved with the market for corporate control?
Pros:
- Substantial lessening in competition > bidder has more incentive to operate efficiently given threat of competition.
Cons:
- Hinder the efficient allocation of resources by allowing firms that are wasting resources to continue to operate, rather than be acquired by firms that are better able to utilize them
