Topic 7 - Mergers and Acquisitions

Question 1

What are two characteristics of a merger?

Answer 1

• One firm is acquired by another

- Acquiring firm retains name and acquired firm ceases to exist

Question 2

What are the advantages and disadvantages of a merger?

Answer 2

• Advantage – legally simple

- Disadvantage – must be approved by stockholders of both firms

Question 3

What is the process of consolidation?

Answer 3

Entirely new firm is created from combination of existing firms

Question 4

How is a firm acquired?

Answer 4

By another firm or individual(s) purchasing voting shares of the firm’s stock.

Question 5

What is a Tender offer?

Answer 5

Public offer by acquirer to buy shares

Question 6

What are the characteristics of a Stock acquisition? (3)

Answer 6

• No stockholder vote required
• Can deal directly with stockholders, even if management is unfriendly
• May be delayed if some target shareholders hold out for more money – complete absorption requires a merger

Question 7

What are three acquisition classifications?

Answer 7

• Horizontal: both firms are in the same industry
• Vertical: firms are in different stages of the production process
• Conglomerate: firms are unrelated

Question 8

Why do most acquisitions fail to create value for the acquirer? (2)

Answer 8

• Failure to successfully integrate two companies after a merger
• Intellectual capital often walks out the door when acquisitions aren’t handled carefully

Question 9

When do Acquisitions deliver value? (3)

Answer 9

• Scale economies or market power,
• Better products and services in the market, or
• Learning from the acquired firm

Question 10

What are four sources of synergy?

Answer 10

• Revenue Enhancement
• Cost Reduction (replacing mgmt)
• Tax Gains (Net Operating Losses,Unused Debt Capacity)
• Incremental new investment required in working capital and fixed assets

Question 11

What are considered “bad” reasons for merger?

Answer 11

• Earnings growth (if not synergies then increased EPS is just due to larger firm, not true growth)
• Diversification (can be achieved through stock purchases)

Question 12

What happens to bondholders and equity holders value when two firms with debt merge? how could shareholders increase their value in the merger?

Answer 12

• value of shareholders call option (equity) falls
• value of debt rises because standard deviation (risk) falls
• if there is no debt no synergies are transferred to the bondholders, i.e. retire debt pre merger or increase debt post merger.

Question 13

What is the typical analysis a firm would do when considering a merger?

Answer 13

NPV

Question 14

What are the 3 NPV formula for a merger?

Answer 14

NPV of acquirer = synergy - premium
NPV of acquirer = Vab - Va - Price paid for B
NPV of acquirer = (Vb + delta V) - cash cost

Question 15

How is synergy calculated?

Answer 15

synergy = Vab - (Va + Vb)

Question 16

How is the premium calculated?

Answer 16

Premium = price paid for b - Value of b

Question 17

What is the formula for the value of the combined firm with only cash consideration paid?

Answer 17

Vab = Va + ((Vb + delta V) - cash cost)

Question 18

Why may a zero-NPV investment be attractive?

Answer 18

If the firm is looking for risk reduction.

Question 19

What is the formula for the value of the combined firm when stock consideration is paid?

Answer 19

VAB = VA + VB + ∆V

Question 20

What does the cost of acquisition depend on with stock consideration?

Answer 20

• Depends on the number of shares offered to the target stockholders
• Depends on the price of the combined firm’s stock after the merger

Question 21

What are 3 considerations when choosing between cash and stock forms of merger consideration?

Answer 21

• Sharing gains: target stockholders do not participate in stock price appreciation with a cash acquisition
• Taxes: cash acquisitions are generally taxable
• Control: cash acquisitions do not dilute control

Question 22

How do we value post-merger shares being offered to target firm shareholders?

Answer 22

Target firm payout = α × New firm value

Where alpha:
α = New shares issued / (Old shares + New shares issued)

Question 23

How is the ownership proportion of the target firm in the new firm expressed?

Answer 23

Ownership = New shares issued / (New shares issued + Current shares of acquiring firm)

Question 24

How do we find the exchange ratio?

Answer 24

Exchange ratio = New shares / Existing shares in target firm

Question 25

In which what way can overvaluation issues of target firms stock be overcome when merging two companies?

Answer 25

If the target firm shares are considered over-priced, or firm A offers ‘too much’ for firm B, A’s shareholders are better off if firm A makes a stock offer, and not a cash offer. The forthcoming bad news about B’s value will then be partly borne by B’s shareholders

Question 26

What are the benefits of cash mergers to the acquiring firms shareholders?

Answer 26

Target firms shareholders receive no money from the share of gains/ downstream synergies resulting from the merger.

Question 27

What’s the difference between a friendly and a hostile takeover?

Answer 27

• Friendly merger, both companies’ management are receptive
• Hostile merger, the acquiring firm attempts to gain control of the target without their approval
  (Tender offer/Proxy fight)

Question 28

What are a negative and a positive to defensive tactics by mgmt to resist takeovers?

Answer 28

• Management resistance may represent the pursuit of self-interest at the expense of shareholders.
• Paradox: Resistance may benefit shareholders in the end if it results in a higher offer premium from the bidding firm or another bidder.

Question 29

Do mergers add value to shareholders? target and acquirer shareholders

Answer 29

• Shareholders of target companies gain more in a tender offer than in a straight merger, price often driven up by resistance from managers
• Shareholders of acquirer firms are found to earn a small excess return in a tender offer, but none in a straight merger.

Question 30

Why do Shareholders of acquirer firms tend to earn a small excess return in a tender offer? (4)

Answer 30

• Anticipated gains from mergers may not be achieved
• Acquirer firms are generally larger, so it takes a larger dollar gain to get the same percentage gain
• Management may not be acting in stockholders’ best interest.
• Announcement may not contain new information about the acquirer firm

Question 31

Why would stock returns of hostile cash acquirers outperform those of friendly cash acquirers?

Answer 31

Unfriendly cash bidders are more likely to replace poor management

Question 32

How is good will accounted for in the acquiring firms books?

Answer 32

It use to be amortised, it now remains on books and is tested for impairment.

Question 33

What does “going private” refer to?

Answer 33

The existing management buys the firm from the shareholders and takes it private

Question 34

What does a leveraged buyout refer to? what are some advantages of a LBO?

Answer 34

• The existing management buys the firm from the shareholders and takes it private and it is financed with a lot of debt.
• Provides a tax deduction for the new owners, while at the same time turning the pervious managers into owners.
• This reduces the agency costs of equity

Question 35

What are Golden parachutes, Crown Jewels and Poison Pills

Answer 35

• Golden parachutes are compensation to outgoing target firm management.
• Crown jewels are the major assets of the target. If the target firm management is desperate enough, they will sell off the crown jewels.
• Poison pills are measures of true desperation to make the firm unattractive to bidders. They reduce shareholder wealth.