Mergers & Acquistions

Question 1

What is a Merger?

Answer 1

A merger is a business transaction in which an acquiring firm absorbs a second firm and the acquiring firm remains in business as a combination of the two merged firms

A merger is legally straightforward; however, approval of the shareholders of EACH firm is required

Question 2

What is a Consolidation?

Answer 2

A consolidation is similar to a merger, but a NEW entity is formed and neither of the merging entities survive

Question 3

What are the 4 types of mergers that are recognized?

Answer 3

Four types of mergers are recognized:

1. Horizontal merger
2. Vertical merger
3. Congeneric merger
4. Conglomerate merger

Question 4

What is a Horizontal merger?

Answer 4

A horizontal merger occurs when two firms in the same line of business combine

Question 5

What is a Vertical merger?

Answer 5

A vertical merger combines a firm with one of its suppliers or customers

Question 6

What is a Congeneric merger?

Answer 6

A congeneric merger is a combination of firms with related products or services; however, the firms do NOT produce the same product or have a producer-supplier relationship

Question 7

What is a Conglomerate merger?

Answer 7

A conglomerate merger involves two unrelated firms in different industries

Question 8

What is an Acquisition?

Answer 8

An acquisition is the purchase of all of another firm’s assets or a controlling interest in its stock

An acquisition of all of a firm’s assets requires a vote of the firm’s shareholders. It also entails the costly transfer of legal title, but it avoids the minority interest that may arise if the acquisition is by purchase of stock

Question 9

Why is an acquisition by stock purchase more advantageous?

Answer 9

An acquisition by stock purchase is advantageous because it can be effected when management and the board of directors are hostile to the combination and it does NOT require a formal vote of the firm’s shareholders

If the acquiring firm’s offer is rejected by the acquiree’s management, a tender offer may be made directly to the acquiree’s shareholders to obtain a controlling interest

Note: An acquisition of stock may eventually result in the merger or consolidation of the two firms

Question 10

What is a Tender offer?

Answer 10

A tender offer is a general invitation by an individual or a corporation to all shareholders of another corporation to tender their shares for a specified price

The tender offer may be friendly (acceptable to the target corporation’s management) or hostile. If it is hostile, the target must also file a statement with the SEC. The target has 10 days in which to respond to the bidder’s tender offer

A tender offer must be kept open for at least 20 business days

Question 11

What does the Williams-Act entail?

Answer 11

In 1968, Congress enacted the Williams Act to extend reporting and disclosure requirements under the SEC Act of 1934 to tender offers

Any person or group that acquires more than 5% of a class of registered securities is required (within 10 days of the tender) to file a statement with the SEC and the issuing company

Question 12

What is referred to as a “Saturday night special” or hostile takeover?

Answer 12

Direct solicitation of shareholders when management and the board resist the combination (resting a tender offer) has been called a Saturday night special or a hostile takeover

This solicitation may be by advertisement in the media or when a shareholder list can be obtained by a general mailing

Question 13

How is takeover used to describe business combinations?

Answer 13

Takeover is a broad term often used in the description of business combinations. It signifies a shift of control from one set of shareholders to another and may be friendly or hostile

A takeover includes not only mergers and acquisitions, but also proxy contests and going private

Question 14

What is a Proxy contest?

Answer 14

A proxy contest is an attempt by dissident shareholders to gain control of the corporation (or at least to gain influence) by electing directors

Question 15

What is a Proxy?

Answer 15

A proxy is a power of attorney given by a shareholder that authorizes the holder to exercise the voting rights of the shareholder

Question 16

What are rules regarding Proxies?

Answer 16

The following are rules regarding proxies:

1. 10 days prior to mailing a proxy statement to shareholders, the issuer must file a copy with the SEC
2. SEC rules require the solicitor of proxies to furnish shareholders with all material information concerning the matter subject to vote
3. A form by which shareholders may indicate their agreement or disagreement must be provided
4. Proxies solicited for the purpose of voting for directors must be accompanied by an annual report

Question 17

What does going private entails?

Answer 17

Going private entails the purchase of the publicly owned stock of a corporation by a small group of private investors, usually including senior managers. Accordingly, the stock is delisted (if it is traded on an exchange) because it will no longer be traded

Such a transaction is usually structured as a leveraged buyout

Question 18

What is a Leverage buyout (LBO)?

Answer 18

A leverage buyout (LBO) is a financing technique by which a company is purchased using very little equity. The cash-offer price is financed with large amounts of debt

An LBO is often used when a company is sold to management or some other group of employee, but it is also used in hostile takeovers

The company’s assets serve as collateral for a loan to finance the purchase

Question 19

What type of securities are usually issued for leverage buyouts (LBOs)?

Answer 19

Junk bonds are often issued in an LBO. They are high-risk and therefore high-yield securities that are normally issued when the debt ratio is very high. Thus, the bondholders will have as much risk as the holders of equity securities

Question 20

What are advantages of leverage buyouts (LBOs)?

Answer 20

The tax deductibility of interest paid by the restructured company is an advantage of an LBO. Given a high debt ratio, that is greater financial leverage, after-tax cash flows increase

The firm may benefit from an LBO because of savings in administrative costs from no longer being publicly traded

Also, if managers become owners, they have greater incentives and operational flexibility

Note: The high degree of risk in LBOs result from the fixed charges for interest on the loan and the lack of cash for expansion

Question 21

What are characteristics of firms that are candidates for a leverage buyout (LBO)?

Answer 21

Characteristics of firms that are candidates for LBO include:

1. An established business with proven operating performance
2. Stable earnings and cash flows
3. Very little outstanding debt
4. A quality asset base that can be used as collateral for a new loan
5. Stable technology that will not require large expenditures for R&D

Question 22

How is merger usually negotiated by the bidder and the acquired firm?

Answer 22

A merger is usually a negotiated arrangement between a single bidder and the acquired firm. Payment is most frequently in stock.

Also, the bidder is often a cash-rich firm in a mature industry and is seeking growth possibilities

The acquired firm is usually growing and in need of cash

Question 23

When would a takeover via tender offer be considered friendly?

Answer 23

When the takeover is friendly:

1. The target is usually a successful firm in a growth industry
2. Payment may be in cash or stock
3. Management of the target often has a high percentage of ownership

Question 24

When would a takeover via tender offer be considered hostile?

Answer 24

When the takeover is hostile:

1. The target is usually in a mature industry and is underperforming (more than one bidder may emerge)
2. Management ownership is likely to be low
3. Payment is more likely to be in cash
4. The initial bidder is probably a corporate raider

Question 25

What is a Greenmail?

Opposition to combination of acquire

Answer 25

A targeted repurchase (greenmail) is a defensive tactic used to protect against takeover after a bidder buys a large number of shares on the open market and then makes (or threatens to make) a tender offer

If management and the board are opposed to the takeover (a hostile tender offer), the potential acquirer is offered the opportunity to sell their already acquired shares back to the corporation at an amount substantially above market value (i.e. paying greenmail)

In conjunction with greenmail, management may reach a standstill agreement in which the bidder agrees NOT to acquire additional shares

Question 26

How can staggered election of directors be a defensive tactic to protect against a takeover?

(Opposition to combination of acquire)

Answer 26

Staggered terms for directors requires new shareholders to wait several years before being able to place their own people on the board

Question 27

How can requiring a “supermajority” approval be a defensive tactic to protect against a takeover?

(Opposition to combination of acquire)

Answer 27

Another anti-takeover amendment to the corporate charter may require a supermajority (i.e. 80%) for approval of a combination

Question 28

What are Golden parachutes?

Answer 28

So-called golden parachutes are provisions passed by a BOD requiring large payments to specified executives if their employment is terminated by the acquiring firm following a takeover

Shareholders have often been unhappy with golden parachute payoffs and have filed suit to stop such payments

Note: A 1984 change in the tax law imposed a 20% excise tax on such payments and provided for their non-deductibility by the corporation. It was specifically designed to reduce the use of golden parachutes

Question 29

What are fair price provisions?

Answer 29

Fair price provisions (shareholder rights plans) have become popular

Warrants are issued to shareholders that permit purchase of stock at a small percentage (often half) of market price in the event of a takeover attempt

The plan is intended to protect shareholder interest if the corporation is confronted by a coercive or unfair takeover attempt

The objective is not to deter takeovers, but to ensure that all shareholders are treated equally

In the event of a friendly tender offer, the outstanding stock rights (warrants) may be repurchased by the corporation for a few cents per share, thus paving the way for the takeover

In many cases, these rights are not even issued in certificate form to shareholders because they are not immediately exercisable and are not traded separately from the common stock

Question 30

What is a Poison pill?

Opposition to combination of acquire

Answer 30

A target corporation’s charter, bylaws or contracts may include a wide variety of provisions that reduce the value of the target to potential tender offerors (i.e. a valuable contract may terminate by its terms upon a specified form of change of ownership of the target)

A poison pill is typically a right to purchase shares (at a reduced price) in the merged firm resulting from a takeover

Question 31

What are Flip-over rights?

Opposition to combination of acquire

Answer 31

The charter of a target corporation may provide for its shareholders to acquire in exchange for their stock (in the target) a relatively greater interest (i.e. twice the shares of stock of equivalent value) in an acquiring entity

Question 32

What are Flip-in rights?

Opposition to combination of acquire

Answer 32

Acquisition of more than a specified ownership interest (i.e. 25%) in the target corporation by a raider is a contingency, the occurrence of which triggers additional rights in the stock other than the stock acquired by the raider (i.e. each share becomes entitled to 2 votes)

Question 33

How can issuing stock be a defensive tactic to protect against a takeover?

(Opposition to combination of acquire)

Answer 33

The target corporation significantly increases the amount of outstanding stock

Question 34

How can a reverse tender be a defensive tactic to protect against a takeover?

(Opposition to combination of acquire)

Answer 34

The target corporation may respond with a tender offer to acquire control of the tender offeror

Question 35

How can an ESOP be a defensive tactic to protect against a takeover?

(Opposition to combination of acquire)

Answer 35

The trustees of an employee stock ownership plan are usually favorable to current management. Thus, they are likely to vote the shares allocated to the ESOP against a raider, who will probably destabilize the target corporation’s current structure

Question 36

How can a white knight merger be a defensive tactic to protect against a takeover?

(Opposition to combination of acquire)

Answer 36

Target management arranges an alternative tender offer with a different acquirer that will be more favorable to incumbent management and shareholders

Question 37

How can a crown jewel transfer be a defensive tactic to protect against a takeover?

(Opposition to combination of acquire)

Answer 37

The target corporation sells or otherwise disposes of one or more assets that made it a desirable target

Question 38

How can legal action be a defensive tactic to protect against a takeover?

(Opposition to combination of acquire)

Answer 38

A target corporation may challenge one or more aspects of a tender offer

A resulting delay increases costs to the raider and enables further defensive action

Question 39

What is a Spin-off?

Other restructurings

Answer 39

A spin-off is the creation of a new separate entity from another entity, with the new entity’s shares being distributed on a pro rata basis to existing shareholders of the parent entity

Existing shareholders will have the same proportion of ownership in the new entity that they had in the parent

A spin-off is a type of dividend to existing shareholders

Note: Reasons for spin-offs include governmental antitrust litigation, refocusing of a firm’s operations and raising capital for the core business operation

Question 40

What is a Divestiture?

Other restructurings

Answer 40

A divestiture involves the sale of an operating unit of a firm to a 3rd party

Note: Some writers define the term divestiture to include spin-offs and liquidations

Note: Reasons for divestitures include governmental antitrust litigation, refocusing of a firm’s operations and raising capital for the core business operation

Question 41

What does a liquidation of assets occur?

Other restructurings

Answer 41

A liquidation of assets of an operating unit occurs when they are sold piecemeal

Question 42

What is a leveraged cash-out?

Other restructurings

Answer 42

A leverage cash-out is borrowing heavily to issue a very large dividend which acts as a poison pill

Question 43

What is an equity carve-out?

Other restructurings

Answer 43

An equity carve-out involves the sale of a portion of the firm through equity offering of shares in the new entity to outsiders

Question 44

What is Letter stock (tracking stock or targeted stock)?

Answer 44

Letter stock (aka tracking stock or targeted stock) is created by a conglomerate to separate the cash flows of 2 or more businesses and allow for separate market valuations

Question 45

What has been factors attributed to increase in mergers and acquisitions?

Answer 45

The level of mergers and acquisitions increased dramatically in the 1980s because of changes in the global and U.S. economies, technological advances, political events, interest and exchange rate fluctuations, the emergence of new financial instruments among other factors such as:

1. General undervaluation of stocks in the early 1980s
2. High inflation that increased the replacement cost of a firm’s assets
3. Political acceptance of large mergers (especially in view of greater competition). For example, as a result of the increased strength of large firms, deregulation, the emergence of new financial services and the development of new technologies
4. The decline of the dollar, which facilitated acquisition of U.S. firms by foreign firms

Question 46

What has been factors attributed to increase in mergers and acquisitions?

Answer 46

The level of mergers and acquisitions increased dramatically in the 1980s because of changes in the global and U.S. economies, technological advances, political events, interest and exchange rate fluctuations, the emergence of new financial instruments among other factors such as:

1. The belief of oil, gas and other natural resource companies that reserves could be obtained more cheaply by merger than by exploration
2. Reduced marginal corporate and personal tax rates and an increase in the capital gains rate
3. Deregulation of numerous industries (i.e. transportation, oil, gas, broadcasting, cable, banking, the S&L industry and other financial services)
4. The U.S. government’s budget deficits, the nation’s trade deficits, high interest rates and other economic factors
5. Defensive combinations by takeover targets

Question 47

How can an acquirer perception of a target firm’s inefficient management be a motivator for a takeover?

Answer 47

Inefficient management may be replaced in a merger or acquisition by the management of the acquiring or merging firm or the competency of existing management may be improved

Question 48

How can an acquirer perception of a target firm undervaluation be a motivator for a takeover?

Answer 48

Undervaluation of the firm to be acquired may result if the market focuses on short-term earnings rather than long-term prospects. Thus, such a firm may be a bargain for the acquirer

Question 49

How is a target firm’s Q ratio affected by an acquirer motivation for a takeover?

Answer 49

One aspect of undervaluation is that a firm’s Q ratio (Market value of the firm’s securities / Replacement cost of assets) may be less than 1

Hence, an acquiring firm that wishes to add capacity or diversify into new product lines may discover that a combination is less expensive than internal expansion

Question 50

How can managerial motivation be a motivator for an acquirer to want to undertake a takeover even if it may NOT be favorable to shareholders?

Answer 50

Managerial motivation is an issue because not all business decisions are based purely on economic considerations

Thus, the increased salary, fringe benefits, power and prestige that often result from managing a larger enterprise may affect a manager’s decision to consummate a business combination that is NOT favorable to the shareholders

Question 51

How can managerial motivation be a motivator for an acquirer to NOT want to undertake a takeover that would be favorable to the acquirer?

Answer 51

Fear of negative personal consequences may cause a manager to resist a favorable combination, perhaps by entering into another combination that preserves the manager’s position by making the firm a less desirable acquisition

Question 52

What is the concept of the “agency problem”?

Answer 52

The inconsistency between a manager’s personal goals and the goal of maximizing shareholder wealth has been called the agency problem

It arises from the separation between ownership and control of corporations. When the manager does not own all of the firm’s shares, the manager is an agent for the other shareholders and a possible conflict of interest exists

Managerial actions will have costs and benefits that are shared by others. Accordingly, a manager may be more inclined to incur certain costs and less inclined to pursue certain benefits

Question 53

What are ways to address the “agency problem”?

Answer 53

Ways of addressing the agency problem include:

1. Tying managerial compensation to the firm’s stock price performance
2. Direct shareholder intervention (especially by large institutional investors such as pension funds and insurance companies)
3. Threat of a hostile takeover (which often results in the ouster of incumbent management)

Shareholders often seek more independence for the board of directors and the ability to introduce a wider range of proposals to be voted on at shareholder meetings

Question 54

What is the argument that diversification is an advantage of a combination?

Answer 54

Diversification is sometimes claimed to be an advantage of a combination because it stabilizes earnings and reduces the risks to employees and creditors

Thus, the coinsurance effect applies. If one of the combining firms fails, creditors can be paid from assets of the other

Question 55

What is the argument that diversification does NOT benefit shareholders in a business combination?

Answer 55

Whether shareholders benefit from diversification is unclear. The variability of the firm’s returns is subject to systematic and unsystematic risk. Systematic risk affects all firms and cannot be diversified

Another argument supporting the view that diversification by itself does not benefit shareholders is that the decrease in earnings variability increases the value of debt at the expense of equity

Absent synergy, the value of the combined firm is the same as the total of the values of the separate firms. Because the debt increases in value as a result of the decreased risk of default (the coinsurance effect), the value of the equity must therefore decrease if the total value of debt and equity is unchanged

Nevertheless, the coinsurance effect can be offset by issuing additional debt after the combination, thereby increasing the firm’s unsystematic risk and decreasing the value of the debt. Also, the greater leverage may increase the firm’s value. Another possibility is reducing debt prior to the combination at the lower pre-combination price and reissuing the same amount of debt afterward

Question 56

What is Synergy?

Answer 56

Synergy exists if the value of the combined firm exceeds the sum of the values of the separate firm

It can be determined by using the risk-adjusted discount rate (usually the cost of equity of the acquired firm) to discount the incremental cash flows (changes in revenues, costs, taxes and capital needs) of the newly formed entity

Question 57

What is Operational synergy?

Answer 57

Operational synergy arises because the combined firm may be able to increase its revenues and reduce costs

For example, the new firm created by a horizontal merger may have a more balanced product line and a stronger distribution system

Also, costs may be decreased because of economies of scale in production, marketing, purchasing and management

Question 58

What are Operating economies?

Answer 58

Operating economies arise from vertical integration because of the improved coordination of successive activities in the production process

Question 59

What is Financial synergy?

Answer 59

Financial synergy may result from a combination. The cost of capital for both firms may be decreased because the cost of issuing both debt and equity securities is lower for larger firms

Also, uncorrelated cash flow streams will provide for increased liquidity and a lower probability of bankruptcy

Another benefit is the availability of additional internal capital. The acquired company is often able to exploit new investment opportunities because the acquiring company has excess cash flows

Note: A combination may provide not only specific new investment opportunities, but also a strategic position that will allow the combined entity to exploit conditions that may arise in the future

For example, the acquisition of a firm in a different industry may provide a beachhead that eventually permits development of a broad product line if circumstances are favorable

Question 60

Does greater market power because of reduced competition serve as a benefit of business combinations?

Answer 60

No

Greater market power because of reduced competition might appear to be a benefit of business combinations, but the evidence does NOT support this conclusion

Antitrust restrictions, the globalization of markets and the emergence of new forms of competition work against concentration of market power

Question 61

What could be a tax advantage of a business combination?

Answer 61

Tax benefits may arise form a combination if the acquired firm has an unusual net operating loss and the acquiring firm is profitable

Another advantage is that the combined firm’s capital structure may allow for increased use of debt financing, with attendant tax savings from greater interest deductions

A combination may be the best use of surplus cash from a tax perspective. Dividends received by individual shareholders are fully taxable, whereas the capital gains form a combination are not taxed until the shares are sol

In addition, amounts remitted from the acquiring firm are not taxable