Week 10 - Mergers, corporate governance & control

Question 1

5 valid sources of value for M&A

Answer 1

1. Necessary restructuring
2. Market power
3. Synergies and economies of scale (higher cash flows, ie. increase revenue, lower costs)
4. Reduction in taxes
   - interest tax shields (advantage of debt, not merger however)
5. Realign managements’ incentives
   - replace bad managers to get rid of agency costs

Question 2

4 dubious sources of value for M&A

Answer 2

1. Increase financial slack, ie. get cash
   - however, essentially spending a pound to buy a pound
2. Diversification at firm level
   - cheaper for investors to diversify at personal level by holding a portfolio
3. Buy a low price target to boost EPS?
   - Note that a change in EPS is an UNRELIABLE indicator of whether the NPV of an acquisition is +ve or -ve; whether shareholders are better off from M&A
   - E/P ratio determined risk of firm & PVGO. Hence why target firm might have LOWER E/P ratio (ie. riskier and/or lower PV of growth opportunities) or HIGHER EPS
   - Bottom line: there must be a reason why target firm has a higher EPS to begin with
4. Overconfidence of CEO’s
   - overestimate benefits of M&A or underestimate costs. They might think M&A is a +ve NPV project.

Question 3

Due to asymmetric information, optimistic managers prefer to finance mergers with CASH. Why?

Answer 3

1. If finance a merger with shares, it is essentially a SHARE ISSUANCE to target shareholders.
2. This means giving away money to target shareholders if shares are underpriced (pecking order theory)
3. or Managers of acquiring firm could be overconfident if think co. is underpriced & giving away underpriced shares

Question 4

Formulae for…
1. Gain from merger
2. Cost of cash-financed merger
3. NPV of acquisition
4. Cost if merger is financed by ACQUIRER’S STOCK

*Cost represents the acquisition premium

Answer 4

1. Gain = V_AT - (VA + VT)
2. Cost = cash paid - VT
3. NPV = gain - cost
4. Cost = (N x P_AT) - VT
   » or (% stake of sellers’ stock in merged company x V_AT) - VT

Question 5

Change in EPS, eg. - target has half your EPS but trading for more than half your value
Are shareholders any better or worse off? (from PS10)

Answer 5

Stated another way, TargetCo’s P/E ratio is 12.5 (= 25/2) vs. your company’s 10 (= 40/4).
- This is possible if TargetCo’s earnings are LESS RISKY or if they are EXPECTED to GROW MORE in the future.
- Thus, although your shareholders end-up with lower EPS after the transaction, they have paid a FAIR PRICE, exchanging their £4 per share before the transaction for either lower, but safer EPS after the transaction, or lower EPS that are expected to grow more in the future.
- Either way, focusing on EPS alone CANNOT TELL you whether shareholders are better or worse off.