Lecture 8b: Takeovers 2

Question 1

What are the 9 Economical Reasons for Takeovers (ACRONYM(

Answer 1

MU UCPD FT. EPS

Question 2

TAKEOVER REASON 1: M

Answer 2

Management of Target Company is inefficient

Question 3

What is the evidence to support the inefficient management of the target company? Breakdown the Trend

Answer 3

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.

Question 4

TAKEOVER REASON 2 : C

Answer 4

Complementary Assets

Question 5

Elaborate on TAKEOVER REASON 1 (M)

Answer 5

MANAGEMENT

Takeover replaces managers who are inefficient and too self-interested

Having a more efficient management can increase the value of the firm

Question 6

Elaborate on TAKEOVER REASON 2 (C)

Answer 6

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)

Question 7

Is the argument “complementary assets’ applicable to human resources

Answer 7

Yes. For examples, if T has engineers, B (bigger firm) might want to takeover to use them

Question 8

TAKEOVER REASON 3: U

Answer 8

Target Company is Undervalued

Question 9

Elaborate on TAKEOVER REASON 3 (U)

Answer 9

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 (!)

Question 10

TAKEOVER REASON 4: C

Answer 10

Cost Reductions

Question 11

Elaborate on TAKEOVER REASON 4 (C)

Answer 11

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

Question 12

TAKEOVER REASON 5: P

Answer 12

Increase market power

Question 13

Elaborate on TAKEOVER REASON 5 (P) - Controversial

Answer 13

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

Question 14

TAKEOVER REASON 6: D

Answer 14

Diversification

Question 15

Elaborate on TAKEOVER REASON 6 (D).

Perspective of SH, DH

Answer 15

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

Question 16

TAKEOVER REASON 7: F

Answer 16

Excess Free Cash Flow

Question 17

Elaborate on TAKEOVER REASON 7 (F)

Answer 17

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

Question 18

TAKEOVER REASON 8: T

Answer 18

Tax Benefits

Question 19

Elaborate on TAKEOVER REASON 8 (T).

Tests to satisfy

Answer 19

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

Question 20

Which taxation systems does taxes favor in takeover reason 8 (T)

Answer 20

Classical: Tc + Tp. Lowering Tc is good
Imputation: Tp. No benefits (assuming fully franked)

Question 21

TAKEOVER REASON 9: EPS (Controversial)

Answer 21

Increase EPS and P/E Ratio Effects

Question 22

Elaborate on TAKEOVER REASON 9 (EPS).

Answer 22

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.

Question 23

Empirical Evidence of Takeovers 1: Do takeover comes in waves

Answer 23

Yes. Takeovers are positively correlated with behavior of share prices.

Question 24

Empirical Evidence of Takeovers Wave: Why are there waves

Answer 24

Increase real demand = Increase Equity Returns = Increase productive capacity

As business and consumer confidence increases, takeover increases

Question 25

What is productive capacity in takeovers

Answer 25

Productive efficiency of a firm - Internally (Debt/Equity) or External (TAKEOVERS).

Takeovers are quick way to expand.

Question 26

Empirical Evidence of Takeovers 2: Motivation of Takeovers

Answer 26

1. ) Synergy (37.3%)
2. ) Diversification (29.3%)

Minor points (<10%): Achieve a specific organisational form (10.7%); Acquire target company below replacement cost; Free cash flow; Taxes; Others

Question 27

Empirical Evidence of Takeovers 3: Sources of Synergy

Answer 27

1. ) Operating Economies/Economies of Scale (89.9%)
2. ) Transaction Cost (5.8%)
3. ) Market Power (4.3%)

Question 28

Empirical Evidence of Takeovers 4: Diversification

Perspective of people who agree

Answer 28

1. ) Less devastation in economic downturn (50%)
2. ) Take advantage of seasonality in production cycle (13.9%)
3. ).) Internal capital allocation (12.5%)

Others

Question 29

Empirical Evidence of Takeovers 5a: Target Company Performance Takeover. Before, Around, After

Answer 29

BEFORE announcement = Under performance

AROUND announcement (even in unsuccessful takeovers) = Significant abnormal positive return

AFTER takeover = significant abnormal positive return stays constant

Question 30

Empirical Evidence of Takeovers 5b: Bidding Company Performance Takeover. Before, Around, After

Answer 30

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

Question 31

Who often wins from a takeover

Answer 31

Target company

Question 32

Which method of payment is better (cash/stock) for target and bidding companies

Answer 32

Cash > Stock for both.

Stock can signal overvaluation.

Question 33

Empirical Evidence of Takeovers 5b: Bidding Company poor performance reason 1 (W)

Answer 33

Wealth effects are disguised

Usually, value of bidding&raquo_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)

Question 34

Empirical Evidence of Takeovers 5b: Bidding Company poor performance reason 2 (C) and 2 sub reasons

Answer 34

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)

Question 35

Empirical Evidence of Takeovers 5b: Bidding Company poor performance reason 3 (P)

Answer 35

Takeovers are simply neutral/poor arguments and managements do it for ego.

Question 36

What kind of takeover is reason 1 most applicable to, and why?

Answer 36

Horizontal takeovers - because bidding company managers have the expertise to manage target company operations more efficiently

Question 37

Does inefficient management mean that management is inefficient?

Answer 37

Not necessarily, could be that management are acting in own interest rather than their ability.

Question 38

What is Economies of Scale

Answer 38

Splitting of cost over wider base

Question 39

Empirical Evidence of Takeovers 4: Diversification

Perspective of people who disagree

Answer 39

1. ) Shareholders can diversify themselves (35.7%)
2. ) Parents lose focus of company (31%)
3. ) Firm should stay in business he knows (26.2%)

Linked with Diversification Discount

Question 40

Why is cash better than stock as a method of payment

Answer 40

The market responds negatively to stock.

Question 41

Takeover activity tends to vary significantly over time.

Outline the factors that may explain this variation.

Answer 41

1. ) Share price levels (Share prices reflect an optimistic outlook for investments, some of which will be external)
2. ) Economic shocks that affect particular industries, and are often followed by industry re-structuring
3. ) Legislation (changes in legislative controls and foreign investment regulations)

Question 42

Company can reduce risk by taking over

Do you agree with this statement? Is it a justifiable reason for a takeover

Answer 42

• 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.

Question 43

A company with accumulated tax losses is necessarily a valuable takeover proposition. Discuss this
statement and give a caveat.

Answer 43

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.

Question 44

First, it provides diversification. Takeover statement tutorial question

Answer 44

• 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.

Question 45

Second, he argues that by injecting fresh capital, Budget can be ‘rescued’ and should appreciate markedly in value. Budget works old computers.

Answer 45

• 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.

Question 46

There is no reason for on acquiring company to prefer a cash bid to a stock exchange or vice versa.

Discuss this statement.

Answer 46

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.

Question 47

What are the benefits and costs associated with having the Australian Competition and Consumer
Commission (ACCC) involved with the market for corporate control?

Answer 47

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