Mergers and acquisitions

Question 1

A merger

Answer 1

is a reorganisation of assets between two equalized companies who agree to join together.

Question 2

• A takeover (acquisition)

Answer 2

is the buying of the share capital of one company by another.

Question 3

Horizontal Acquisition 3

Answer 3

1. Companies in the same industry and stage of production combine into a single entity.
2. Most common acquisition and most likely to succeed.
3. Also, the most likely kind of acquisition to be referred to the Competition Commission.

Question 4

Vertical Acquisition 2

Answer 4

1. Companies in the same industry at different stages of production merge, either backwards towards suppliers or forwards towards distribution.
2. Secures vital outlets for finished products or necessary sources of raw materials.

Question 5

Conglomerate Acquisition 3

Answer 5

1. Companies in different industries merge
2. Least likely to be referred
3. Least likely to be successful.

Question 6

Justifications for acquisition 4

Answer 6

1. If market value of new firm exceeds separate market values, shareholder wealth increases
2. Economic motives seek to raise cash flows by increasing revenue or decreasing costs.
3. Synergy arise when complementary activities lead to increasing profit or output.
4. Operating, financial and managerial synergy have been identified.

Question 7

Economies of scale 3

Answer 7

1. Larger scale of operations or more efficient use of assets following an acquisition leads to a decrease in average unit cost.
2. Economies of scale can occur in production, distribution, marketing, etc.
3. Economies of scale may be seen as an operating synergy.

Question 8

Elimination of inefficient management 3

Answer 8

1. If company is poorly run, its share price will fall and it becomes a target for acquisition.
2. Increased output or revenue and lower costs can arise from transfer of managerial skills or elimination of inefficient managers.
3. Managerial skills of acquirer complement assets of target firm, hence higher profits.

Question 9

Increased cash flows can also arise from a range of marketrelated factors: 4

Answer 9

1. New market entry for existing products, e.g. acquisition faster than organic growth
2. Critical mass achieved, e.g. minimum size to effectively carry costs such as R+D
3. Growth of market share
4. Increased market power or market share

Question 10

Financial synergy 4

Answer 10

1. This refers to decrease in cost of capital through acquisition.
2. Increased size can lead to financing scale economies, e.g. lower issue costs.
3. Increased size can yield lower interest rates and lower cost of debt due to lower risk.
4. Decreased cash flow volatility can also decrease risk and lower cost of capital

Question 11

Target undervaluation 4

Answer 11

1. If target company shares are undervalued, capital markets cannot be efficient.
2. Whether a valid reason for acquisition will depend on the view of capital market efficiency.
3. Evidence suggests markets are efficient.
4. Valuation uncertainty does leaves scope for undervaluation

Question 12

Earnings per share 4

Answer 12

1. If acquirer has higher PER than target, it can increase its EPS by using share-for-share offer.
2. If PER stays the same, the market value will rise. • Increasing EPS this way is ‘boot-strapping’.
3. Boot-strapping does not increase the wealth of shareholders as it does not generate cash.
4. Market may give a different value to new firm

Question 13

Managerial motives 4

Answer 13

1. Agency problem can manifest through acquisitions.
2. Motive for acquisitions may be power, remuneration, perks, job security.
3. Managerial motives can lead to decrease in shareholder wealth.
4. Acquiring shareholders rarely benefit.

Question 14

Against acquisition

Answer 14

Referral to Competition Commission:

• Damages image and wealth of acquirer
• Formal investigation means long costly delay
• Acquisition may be blocked or amended

Bid is contested

• Large acquisition premium if bid contested
• Premium up to 50% not uncommon

Cost of financing acquisition

• Share-for-share offer
  
  • Acquirer must pay dividends on new shares
  • Ownership and control changes
• Cash offer (financed by debt)
  
  • Gearing levels may increase sharply
  • Interest payments may be hard to meet
• Acquisition transaction cost to be met.

Other difficulties

• Cultural problems
• Exchange rate risk (cross-border mergers)
• Complex taxation and legal issues
• Quality of assets purchased may be uncertain.

Question 15

Merger waves have been linked to: 6

Answer 15

1. business cycles
2. deregulation of financial system and markets • company profitability and liquidity
3. corporate fads, such as a core business focus or corporate diversification
4. globalisation of markets
5. changing market conditions
6. changes in anti-trust legislation.

Question 16

Stock market valuation 6

Answer 16

1. Number of shares times market price per share
2. Fair price if market is efficient, but not fixed
3. Quoted price reflects marginal trading
4. Cannot be used for unquoted shares
5. Useful starting point in negotiations
6. MV does not reflect acquirer intentions

Question 17

Earnings yield value

Answer 17

should reflect size of firm and nature of its business

Question 18

DCF valuation 4

Answer 18

1. DCF value of target = PV of incremental cash flows gained by acquirer Problems
2. Difficult to quantify expected benefits from operating and financial synergies
3. Difficult to choose appropriate time horizon and terminal value for target
4. Which discount rate should be used?

Question 19

Financing: cash offers

Answer 19

Advantages to bidding company:

• Can see exactly how much is being offered
• No effect on number of issued shares.

A major issue is where the cash comes from:

• Cash from retained earnings is usually insufficient to buy target company shares.
• Pre-bid rights issue could be used.
• Pre-bid bond issue or bank loans could be used, but gearing and interest rate changes must be considered

Question 20

Financing – share-for-share offers

Answer 20

Target company shareholders are offered a fixed number of shares in the bidder in exchange for their shares.

Advantages for target company shareholders:

• Retain equity interest in their company
• No brokerage costs from re-investing cash and no capital gains tax liability

Disadvantages to acquiring company and its shareholders:

• More expensive than cash offers as offer price must protect against fall in market price of bidding company’s shares
• Increases number of shares in circulation
• Share issue may move bidder away from its optimal capital structure.

Question 21

Financing – security packages

Answer 21

Non-equity securities that could be used:

• ordinary bonds
• convertible bonds
• preference shares
• For various reasons, these are no longer popular from a payment point of view and so are rarely seen in practice.

Question 22

Financing – mixed bids

Answer 22

• Mixed bids are where a share-for-share offer is supported by a cash alternative.
• They have become an increasingly popular financing choice because:
  
  • they are seen as being more acceptable to the target company’s shareholders
  • Rule 9 of the City Code on Takeovers and Mergers requires a mixed bid when 30% of target company shares are held.

Question 23

Strategic process of acquiring target company: 6

Answer 23

1. Identify suitable target companies
2. Obtain information on these targets
3. Value each target company and decide on the maximum purchase price
4. Choose most appropriate potential target
5. Identify best way to finance the acquisition
6. Select tactics likely to make bid successful.

Question 24

Reasons for divestment: 5

Answer 24

1. To raise cash to ease liquidity problem
2. To raise cash to reduce gearing
3. To allow firms to focus on core activities and perhaps generate economies of scale
4. Divested assets may be worth more in the hands of specialist managers
5. Crown jewel defence

Question 25

Divestment strategies 4

Answer 25

Sell-offs

Company sells off part of its operations to a third party, usually for cash.

Spin-off or demerger

• Pro rata distribution of subsidiary shares to parent shareholders
• Structure of firm changes, but no assets are sold and control remains with parent.​

Management buyout (MBO)

Purchase of part or all of a firm by incumbent management.

Financing of MBOs

Question 26

Reasons for MBO 3

Answer 26

1. Co-operation of subsidiary’s managers
2. Subsidiary’s managers may believe they can turn around a loss-making situation
3. Solution to marginalisation problem

Question 27

Financing of MBOs

Answer 27

1. Comprehensive business plan essential
2. MBO usually financed by debt and equity
3. Equity finance:

• managers prefer controlling equity stake
• venture capitalists need exit route

Debt finance

Mezzanine finance.

Question 28

Difficulties faced by MBOs 4

Answer 28

1. MBO will need to replace services previously provided by parent
2. Determining a fair price for the MBO
3. Complex MBO tax and legal aspects
4. Maintaining relationships with customers and suppliers

Question 29

Private equity

Question 30

Empirical research The economy 3

Answer 30

1. Cowling et al. (1980) found efficiency gains neutralised by greater monopoly power, although two cases with benefits were noted.
2. Research shows acquisitions have, at best, a neutral effect on economy.
3. Although overall economic wealth may not increase, wealth redistribution can occur

Question 31

Empirical research The shareholders 6

Answer 31

1. Accounting studies indicate that acquisitions are unprofitable to the acquirer.
2. Event studies (before and after comparisons) show that target company shareholders get significant gains while acquiring company shareholders get no gains or even a loss.
3. Bidders may earn gains prior to the bid
4. Gain of target company shareholders’ likely to be a result of bid premium.
5. Acquiring company shareholders’ lack of gain may be due to anticipation of acquisition by efficient market.
6. Many surveys conclude that acquisitions transfer rather than create wealth.

Question 32

Managers and employees

Answer 32

Acquiring company managers benefit from:

• increased power and status
• increased financial rewards
• increased job security

Managers of target companies tend to lose their jobs following an acquisition, while their employees also face uncertain futures

Question 33

Empirical research 3

Answer 33

The winners – acquiring company managers, financial institutions, target company shareholders

Neutral effect – the economy

The losers – acquiring company shareholders, target company managers and employees.