微信客服：xiaoxionga100
微信客服：ITCS521
程序代写案例-1FIN
时间：2022-05-10
1FIN B386F
Financial Decision Making
Learning Objectives Outline
• -
2
Merger &
Acquisition
3 Legal
procedures of
Acquisition
3 Types of
Acquisition
Valuation of
Synergy benefits
from Acquisition
Synergy benefits:
4 main sources
Financing for
Acquisition
By Cash offer
By Share offer
Dubious reasons:
EPS growth &
Diversification
Divestitures &
Corporate
Restructuring
4 Types of
Divestitures
Reasons for
Divestitures
Reasons for failure
Acquisition
Defensive Tactics
Takeovers – The Market for Corporate Control
There are 3 ways to change the management control of a firm.
These are:
a)Acquisition: The purchase of one firm by another in a merger or acquisition
b)Proxy Contest: This is an attempt to gain control of a firm by soliciting enough
stockholder votes to replace existing management
c)Going Private (Leverage buyout): A leverage buyout of a firm by a private group of
investors (When this group is led by the company’s management, the acquisition is
called a management buyout MBO)
3
Mergers and Acquisitions
Three basic legal procedures one firm can use to acquire another firm:
1. Merger or consolidation
2. Acquisition of stock
3. Acquisition of assets
These forms are different from a legal standpoint, but the financial press
frequently does not distinguish between them
• Merger is often used regardless of actual form of the acquisition
• Acquiring firm is referred to as the bidder, the company that offers to
distribute cash or securities to obtain the stock or assets of another
company
• Firm that is sought (and perhaps acquired) is called the target firm
• Cash or securities offered to the target firm are the consideration in
the acquisition
4
Mergers and Acquisitions
Merger is the complete absorption of one company by another, wherein the acquiring
firm retains its identity and the acquired firm ceases to exist as a separate entity. The
bidder remains and the target ceases to exist.
Consolidation is a merger in which an entirely new firm is created and both the
acquired firm and the acquiring firm cease to exist. A new firm is created. Joined firms
cease their previous existence.
The rules for mergers and consolidation ae basically the same. Acquisition by merger
or consolidation results in a combination of the assets and liabilities of acquired and
acquiring firms; the only difference lies in whether or not a new firm is created.
5
Company A
Company B
Company A
Company B ceases to exist
Company A
Company B
Company C
Company A & B no longer exist
Mergers and Acquisitions
Some advantages and some disadvantages of using a merger:
Primary advantage is that a merger is legally simple and does not cost as
much as other forms of acquisition
• Firms agree to combine their entire operations, so there is no need to
transfer title to individual assets of the acquired firm to the acquiring firm
Primary disadvantage is that a merger must be approved by a vote of the
stockholders of each firm
• Typically, two-thirds (or more) of the share votes are required for approval
and obtaining the necessary votes can be time-consuming and difficult.
6
Acquisition of stock
Another way to acquire another firm is to purchase the firm’s voting stock
with an exchange of cash, shares of stock, or other securities
Process will often start as private offer from management of one firm to that
of another.
Tender offer is a public offer by one firm to directly buy the shares of
another firm
• Communicated to the target firm’s shareholders by public
announcements such as those made in newspaper advertisements
• Tender offer is frequently contingent on the bidder’s obtaining some
percentage of the total voting shares
• Shareholders who choose to accept the offer tender their shares by
exchanging them for cash or securities (or both), depending on the offer
7
Acquisition of stock
Some factors involved in choosing between an acquisition by stock and a
merger:
• In an acquisition by stock, no shareholder meetings must be held and no
vote is required
− If the shareholders of the target firm don’t like the offer, they are not
required to accept it and need not tender their shares
• In an acquisition by stock, the bidding firm can deal directly with the
shareholders of the target firm by using a tender offer
• Acquisition is occasionally unfriendly.
− In such cases, a stock acquisition is used to circumvent the target firm’s
management, which is usually actively resisting acquisition
• Frequently, a significant minority of shareholders will hold out in a tender
offer; target firm cannot be completely absorbed when this happens, and
this may delay realization of merger benefits or be costly in some other way
• Complete absorption of one firm by another requires a merger
8
Acquisition of assets
A firm can effectively acquire another firm by buying most or all of its assets
• Target firm will not necessarily cease to exist; it will have just sold off
its assets
• “Shell” will still exist unless its stockholders choose to dissolve it
This type of acquisition requires a formal vote of the shareholders of the
selling firm
• Advantage to this approach is that there is no problem with minority
shareholders holding out
• Disadvantage is that the acquisition of assets may involve transferring
titles to individual assets, and the legal process of transferring assets
can be costly
9
Types of Acquisition
Financial analysts typically classify acquisitions into three types:
1. Horizontal acquisition is an acquisition of a firm in the same industry
as the bidder
• One risk in a horizontal merger is antitrust regulations
2. Vertical acquisition involves firms at different steps of the production
process
3. Conglomerate acquisition occurs when the bidder and the target
firm are in unrelated lines of business
• Popular in the technology area
Firms don’t have to merge to combine their efforts
• Strategic alliance is an agreement between firms to cooperate in
pursuit of a joint goal
• Joint venture is typically an agreement between firms to create a
separate, co-owned entity established to pursue a joint goal
10
A diagram illustrating horizontal integration and contrasting it with
vertical integration.
11
Forward vertical integration when it
controls distribution centers and retailers
where its products are sold.
Backward vertical integration when it
controls subsidiaries that produce some
of the inputs used in the production of its
products.
A diagram illustrating horizontal integration and contrasting it
with vertical integration.
Types of Acquisition
Questions:
Are the following hypothetical mergers horizontal, vertical or conglomerate?
a) IBM acquires the computer manufacturer Lenovo
Horizontal merger. IBM is in the same industry as Lenovo
b) Lenovo acquires Safeway ( a supermarket chain)
Conglomerate merger. Lenovo and Safeway are in different industries.
c) Safeway acquires Campbell Soup
Vertical merger. Safeway is expanding backward to acquire one of its suppliers, Campbell
Soup.
d) Campbell Soup acquires IBM.
Conglomerate merger. Campbell and IBM are in different industries.
12
13
Why might mergers and acquisitions be beneficial?
Synergy Effect ?
• The whole is worth more than the sum of the parts
• Some mergers create synergies because the firm can either cut costs
or use the combined assets more effectively
• This is generally a good reason for a merger
Examine whether the synergies can create enough benefit to justify
the cost for the following 4 basic categories.
a) Revenue enhancement
b) Cost reduction
c) Lower taxes
d) Reduction in capital needed
Synergy
Suppose Firm A is contemplating acquiring Firm B
• Successful merger requires value of the whole (i.e., combined firm) exceed
the sum of the parts (i.e., values of separate firms)
If VAB is the value of the merged firm, and VA and VB are the values of the
separate firms, the merger makes sense only if:
➢VAB > VA + VB (The whole is more than the sum of the parts)
Difference between the value of the combined firm and the sum of the values
of the firms as separate entities is the incremental net gain from the
acquisition, ΔV:
➢ΔV = VAB − (VA + VB)
Synergy is the positive incremental net gain associated with the combination
of two firms through a merger or acquisition
• When ΔV is positive, the acquisition is said to generate synergy
14
Synergy
If Firm A buys Firm B, it gets a company worth VB plus the incremental gain,
ΔV, so the value of Firm B to Firm A (VB
*) is:
Value of Firm B to Firm A (Acquiring firm) = VB
* = ΔV + VB
VB
* can be determined in two steps:
1. Estimating VB
2. Estimating ΔV
If B is a public company, its market value as an independent firm under
existing management (VB) can be observed directly, but if Firm B is not
publicly owned, its value will have to be estimated based on similar
companies that are publicly owned
15
Synergy
To determine the incremental value of an acquisition, we need to know the
incremental cash flows, ΔCF, the cash flows for the combined firm less what A
and B could generate separately:
ΔCF = ΔRevenue − ΔCost − ΔTax − ΔCapital requirements
Merger will make sense only if one or more of these cash flow components
are beneficially affected by the merger.
Possible cash flow benefits of mergers and acquisitions fall into four basic
categories:
a) Revenue enhancement
b) Cost reductions
c) Lower taxes
d) Reductions in capital needs
16
P/L
B/S
Revenue Enhancement
Marketing gains might occur as a result of improvements in the following areas as a
result of changes in advertising efforts, changes in the distribution network, changes
in the product mix.
a) Previously ineffective media programming and advertising efforts
b) A weak existing distribution network
c) An unbalanced product mix
Strategic benefits are opportunities to take advantage of the competitive environment
if certain things occur or, more generally, to enhance management flexibility with
regard to the company’s future operations
• Beachheads – acquisitions that allow a firm to enter a new industry that may
become a platform for further expansion
Increases in market power (reduction in competition or increase in market share) may
result in profit enhancements through higher prices.
• Mergers that substantially reduce competition may be challenged by U.S.
Department of Justice or Federal Trade Commission on antitrust grounds
17
Cost Reductions
Economies of scale relate to the average cost per unit of producing goods and services
• Ability to produce larger quantities while reducing the average per unit cost
• Most common in industries that have high fixed costs
• Spreading overhead refers to sharing central facilities such as corporate
headquarters, top management, and computer services
Economies of vertical integration have a main purpose of making it easier to
coordinate closely related operating activities
• Coordinate operations more effectively
• Reduced search cost for suppliers or customers
• For example, most forest product firms that cut timber also own sawmills and
hauling equipment
Complementary resources are characterized by some firms acquiring others to make
better use of existing resources or to provide the missing ingredient for success
• For example, a ski equipment store may merge with a tennis equipment store
to produce more even sales over both the winter and summer seasons,
thereby better using store capacity
• Anther example: banks that allow insurance or stock brokerage services to be
sold on premises
18
Lower Taxes
Possible tax gains from an acquisition include the following:
a) Take advantage of net operating losses
− Carry-backs and carry-forwards
− Merger may be prevented if the tax authorities believe the sole purpose is
to avoid taxes
b) Unused debt capacity
− Allows merged firms to borrow more giving rise to tax shields
c) Surplus funds
− Under free cash flow, firms are encouraged to pay dividends to remove the
free cash from the firm. This method may result in shareholders having to
pay more taxes. Using the excess cash for acquisitions avoids having to pay
additional taxes.
• Net operating losses (NOL) are tax losses a firm cannot use because they
lost money on a pretax basis (and will not pay taxes)
19
Reductions in Capital needs
All firms must invest in working capital and fixed assets to sustain an efficient
level of operating activity
‒ A merger may reduce the required investment in working capital and fixed
assets relative to the two firms operating separately
Acquiring firms may be able to manage existing assets more effectively under
one umbrella
‒ Can occur with a reduction in working capital resulting from more efficient
handling of cash, accounts receivable, and inventory
Acquiring firm may also sell off certain assets that are not needed in the
combined firm
‒ Some assets may be sold if they are redundant in the combined firm (this
includes reducing human capital as well)
20
Analytical income statement
Sales
- Total variable costs
- Fixed costs
EBIT (Operating income)
- Interest
EBT
- Taxes
Net income
21
Revenue Enhancement
Cost
Reductions
Lower Taxes
Dubious reason for EPS Growth
• Mergers and acquisition may give the appearance of growth in EPS without
actually changing cash flows.
• Buying a firm with a lower P/E ratio can increase earnings per share. But the
increase should not result in a higher share price.
• If there are no synergies or other benefits to the merger, then the growth in EPS is
not true growth.
• Example:
• Suppose Global Resources, Ltd., acquires Regional Enterprises, but the merger
creates no additional value; after the merger we should have the following
information if the market is smart.
• Global will have 140 shares outstanding
• Market value of the combined firm is $3,500
• Earnings per share of the merged firm are $1.43
• Because the stock price of Global after the merger is the same as before the
merger, the price-earnings ratio must fall.
22
Dubious reason for EPS Growth
Acquisition can create appearance of EPS growth
• Suppose Global Resources, Ltd., acquires Regional Enterprises.
• The financial positions of both firms before the acquisition is shown below.
• Assume the merger creates no additional value, so the combined firm (Global Resources after
acquiring Regional) has a value that is equal to the sum of the values of two firms before the
merger.
• Before the merger, both firms have 100 shares outstanding. However, Global sells for $25 per
share versus a price of $10 per share for Regional.
• Global acquires Regional by exchanging 1 of its share for every 2.5 shares in Regional. Because
there are 100 shares in Regional, this will take 100/2.5 = 40 shares in all.
• After the merger, Global will have 140 shares outstanding and several things will happen.
23
Dubious reason for EPS Growth
The market value of the combined firm is $3,500, that is $2,500 plus $1,000. This is equal to the
sum of the values of these 2 firm before the merger and the price per share $3,500/140 = $25
If the market is “smart”, it will realize that the combined firm is worth the sum of the values of
these 2 separate firms.
The earnings per share of the merged firm is $1.43 ($200/140) and the acquisition enables Global
to increase its earnings per share from $1 to $1.43, an increase of 43 %.
Because the stock price of Global after the merger is the same as before the merger (the merger
creates no additional value), the price-to-earnings ratio must fall to 17.50, that is, $25/$1.43 and
recognizes that the total market value has not been altered by the merger.
24
P/E must fall
$200/140
$3,500/140
$2,500+ $1,000
Dubious reason for EPS Growth
If the market is “fooled”, it might mistake the 43% increase in earnings per share for true growth.
In this case, the PE ratio of Global may not fall after the merger and remains equal to 25.
Because the combined firm has earnings of $200, the total value of the combined firm will
increase to $5,000 (25 x $200).
The per share value for Global will increase to $35.71 ($5,000/140).
This is earnings growth is illusion only as can be seen, the merger does not create value.
25
Bootstrapping
In the previous example, Global takes over Regional and it is assumed that the post
acquisition value of the combined company can be estimated by applying Global’s P/E
ratio to be combined company’s earnings.
This is known as bootstrapping and it is based on that the market will assume that the
management of the acquiring company will be able to apply common approach to
both companies after the takeover, thus improving the performance of the acquired
company by using the methods that they have been using on their own company
before the takeover.
26
Dubious reason for Diversification
• Diversification is commonly mentioned as a benefit of a merger, but
diversification is not a good reason for a merger because:
• Diversification doesn’t create value itself because diversification reduces
unsystematic, not systematic risk.
• Value of an asset depends on its systematic risk, and systematic risk is
not directly affected by diversification
• Because the unsystematic risk is not especially important, there is no
particular benefit from reducing it
• Stockholders can get all the diversification they want by buying stock in
different companies. They can diversify their own portfolio more cheaply
than a firm can diversify by acquisition.
• As a result, they won’t pay a premium for a merged company for the
benefit of diversification
• Reducing unsystematic risk benefits bondholders by making default less
likely.
27
The Cost of an Acquisition by Cash and Stock
We learned earlier the net incremental gain from a merger is:
ΔV = VAB − (VA + VB)
Total value of Firm B to Firm A, VB
*, is:
VB
*= VB + ΔV
Net present value (NPV) of the merger is:
NPV = VB
*− Cost to Firm A of the acquisition
Suppose the premerger information below applies for Firms A and B:
• Both of these firms are 100% equity
• You estimate the incremental value of the acquisition, ΔV, is $100
• Board of Firm B has indicated that it will agree to a sale if the price is $150, payable
in cash or stock
28
The cost of an acquisition: Cash acquisition
Should Firm A acquire Firm B? Should it pay in cash or stock?
Value of Firm B to Firm A is:
VB
* = ΔV + VB
= $100 + $100 = $200
If Firm A pays $150 in cash to purchase all the shares of Firm B, the cost of acquiring
Firm B is $150 and the NPV of a cash acquisition is:
NPV = VB
* − Cost
= $200 − $150 = $50
After the merger, Firm AB will still have 25 shares outstanding
Value of Firm A after the merger is:
VAB = VA + (VB
*− Cost)
= $500 + $200 − $150
= $550
Price per share after merger is $550/25 = $22, representing a gain of $2 per share
29
The cost of an acquisition: Stock acquisition
Value of merged firm in this case will equal the premerger values of Firms A and B plus
the incremental gain from the merger, ΔV:
VAB = VA + VB + ΔV
= $500 + $100 + $100
= $700
To give $150 worth of stock for Firm B, Firm A will have to give up $150/$20 = 7.5
shares
After the merger, there will be 25 + 7.5 = 32.5 shares outstanding, and the per share
value will be $700/32.5 = $21.54
Total value of consideration received by B’s stockholders is 7.5 × $21.54 = $161.54
NPV of the merger to Firm A is:
NPV = VB
* − Cost
= $200 − $161.54 = $38.46
Cash acquisition (from previous slide) is better in this case for Company A (the
acquirer).
30
31
Stock Acquisition
• Evaluating the terms of a merger can be tricky when there is an exchange of
shares as the cost of acquisition:
• Depends on the number of shares given to the target stockholders
• Depends on the price of the combined firm’s stock after the merger
Acquisition by Cash and Stock (Example)
Acquiring Food Company is considering acquisition of a smaller company, Target Food
Company.
Acquiring Food Company is proposing to finance the deal by purchasing all of Target’s
outstanding stock for $19 per share.
Some financial information for these 2 companies is given below.
Cost of capital is 20%.
32
Acquisition by Cash and Stock (Example)
a) Why would Acquiring Food and Target Food be worth more together than apart?
As can be see, the operating costs can be reduced by combining the companies’
marketing, distribution and administration by $2 million per year.
Revenue can also be increased in Target Food’s region by another $2 million per year.
The earnings for the two firms operating together will increase projected earnings by
$4 million.
Assuming this increased earnings are the only synergy to be generated by the merger.
The economic gain to the merger is the present value of the extra earnings.
If the earnings increase in permanent ( a perpetuity) and the cost of capital is 20%.
The present value of synergy (economic gain) is $4 million / 0.2 = $20 million
33
Acquisition by Cash and Stock (Example)
b) What is the cost of acquisition to Acquiring Food Company by cash?
• In this case, it is a cash offer of $19 per share and $3 per share over the current
market price ($16).
• Target Food has 2.5 million outstanding shares and Acquiring Food has to pay a
premium of $3 x 2.5 million = $7.5 million over Target’s market value.
• Target shareholders will capture $7.5 million out of $20 million gain form the
merger, leaving $12.5 million gain to Acquiring shareholders.
NPV cash to Acquiring Food
= Value of Target Food + PV of Synergy – Cost paid to Target Food
= $16 x 2.5 million + $20 million - $19 x 2.5 million
= $40 million + $20 million - $47.5 million
= $12.5 million
34
Acquisition by Cash and Stock (Example)
c) What is the cost of acquisition to Acquiring Food Company by stock?
Suppose Acquiring Food would like to conserve cash and elect to pay Target Food
shareholder by stock.
The deal call for Target Food shareholders to receive 1 Acquiring Food for every 3
shares of Target Food.
In this case, 2.5 million Target shares will result in issue of 2.5 million / 3 = 0.833
million shares of Acquiring Food.
That means after the acquisition, there will be 10 million + 0.833 million = 10.833
million of shares in the merged firm.
Total value of merged firm
= Value of Acquiring Food + Value of Target Food + PV of Synergy
= $48 x 10M + $16 x 2.5M + $20M =$480M + $40M + $20M
= $540M
Share price after merger = $540M / 10.833M = $49.85
35
Acquisition by Cash and Stock (Example)
The value of shares given to Target’s original shareholders is 0.833 million x $49.85 =
$41.5 million
NPV stock to Acquiring Food
= Value of Target Food + PV of Synergy – Value of shares paid to Target
= $16 x 2.5 million + $20 million – $49.85 x 0.833 million
= $40M + $20M + 41.5M
= $18.5M
This is higher than cash offer $12.5M and therefore, share offer is better than cash
offer for Acquiring Food Company.
There is a key distinction between cash and stock offer for financing mergers.
If cash is offered, the cost of merger is not affected by the size of the merger gains.
If stock is offered, the cost depends on the gains because the gains show up in the
post merger share price, and these shares are used to pay for the acquired firm.
36
Acquisition by Cash and Stock (Example)
Suppose Target Food shareholders demand 1 Acquiring share for every 2.5 Target Food
shares. Otherwise, they will not accept the offer.
Under these revised terms, is the merger still a good deal for Acquiring Food?
In this case, 2.5 million Target shares will result in issue of 2.5 million / 2.5 = 1 million
shares of Acquiring Food.
That means after the acquisition, there will be 10 million + 1 million = 11 million of
shares in the merged firm.
Total value of merged firm remains the same as:
= Value of Acquiring Food + Value of Target Food + PV of Synergy
= $48 x 10M + $16 x 2.5M + $20M =$480M + $40M + $20M
= $540M
Share price after merger = $540M / 11 = $49.09
37
Acquisition by Cash and Stock (Example)
The value of shares given to Target’s original shareholders is 1 million x $49.09 =
$49.09 million
NPV stock to Acquiring Food
= Value of Target Food + PV of Synergy – Value of shares paid to Target
= $16 x 2.5 million + $20 million – $49.09 x 1 million
= $40M + $20M - 49.09M
= $10.91M
This is positive and therefore, Acquiring Food Inc. should accept it.
In this case, cash offer $12.5M is better then share offer $10.91M from Acquiring Food
Inc.’s position.
38
39
Cash versus Common Stock
Distinction between cash and common stock financing in a merger is an important
one
• If using cash, cost of acquisition is not dependent on acquisition gains
• All else equal, if common stock is used, cost is higher because Firm A’s
shareholders (acquiring firm) must share acquisition gains with shareholders of
Firm B (target company)
Whether a firm should finance an acquisition with cash or with shares of stock
depends on several factors, including the following:
Considerations when choosing between cash and stock
a) Sharing gains: If cash is used to finance an acquisition, selling firm’s
shareholders will not participate in potential gains from the merger
b) Taxes: Acquisition by paying cash often results in taxable transaction, while
acquisition by exchanging stock is usually tax-free
c) Control: Acquisition by paying cash does not affect control of acquiring firm,
while acquisition with voting shares may have implications for control of
merged firm
Typically, cash financing is more common than stock financing
Cash versus Common Stock
• Because of asymmetric information, the acquiring firm knows best the true value of
its own stock
• If the acquiring firm thinks that its own stock is overvalued, it has an incentive to
pay with stock, since the target firm’s shareholders would be getting less than the
stock price suggests (this assumes that in the long run, the market will correct itself
and the price will fall)
40
Cash and Share offer: Advantages and Disadvantages
In a cash offer, the target company shareholders are offered a fixed cash sum per
share.
➢ Advantages
• When the bidder has sufficient cash the takeover can be achieved quickly at low
cost.
• Target company shareholders have certainty about the bid’s value i.e. there is less
risk compared to accepting shares in the bidding company.
• There is increased liquidity to target company shareholders, i.e. accepting cash in a
takeover, is a good way of realizing an investment.
• The acceptable consideration is likely to be less than with a share exchange as there
is less risk to target company shareholders. This reduces the overall cost of the bid
to the bidding company.
➢ Disadvantages
• With larger acquisition the bidder must often borrow in the capital markets or issue
shares in order to raise the cash. This may have an adverse effect on gearing and
also cost of capital due to the increased financial risk.
• For target company shareholders, this is a taxable gain for cash received.
• Target company shareholders may be unhappy with a cash offer because they
cannot participate in the new company.
41
Cash and Share offer: Advantages and Disadvantages
In a share exchange, the bidding company issues some new shares and then
exchanges them with the target company shareholders.
➢ Advantages
• The bidding company does not have to raise cash to make the payment
• Shareholder capital is increased and gearing similarly improved as the shareholders
of the acquired company become shareholders in the post acquisition (merged)
company.
• A share exchange can be used to finance very large acquisitions.
• The gain due to share exchange is not taxable transaction.
➢ Disadvantages
• The bidding company’s shareholders have to share future gains with the acquired
entity and the current shareholders will have a lower proportionate control and
share in profits of the combined entity than before.
• Price risk – there is price risk that the market price of the bidding company’s shares
will fall during the bidding process which may result in the bid failing
• For example, if a 1 or 2 share exchange is offered based on the fact that the bidding
company’s shares are worth approximately double the value of the target
company’s shares, the bid might fail if the value of the bidding company’s shares
falls before the acceptance date.
42
Why mergers and acquisitions fail?
➢ Unrealistic Price Paid for target (Paying too much)
• The process of M&A involves valuation of the target company and paying a price for
taking over the assets of the company.
• Quite often, one finds that the price paid to the target company is much more than
what should have been paid
• While the shareholders of the target company stand benefited the shareholders of
the acquired end up on the losing side.
➢ Overstated Synergies
• Mergers and acquisitions are looked upon as an important instrument of creating
synergies through increased revenue, reduced costs, reduction in working capital
and improvements in the investment intensity.
• Overestimated of these can lead to failures of mergers and acquisitions.
43
Why mergers and acquisitions fail?
➢ Difficulties in Cultural Integration
• Every merger involves combining of two or more different entities.
• These entities reflect corporate cultures, styles of leadership, differing employee
expectations and functional differences.
• If the merger is implemented in a way that does not deal sensitivity with the
companies’ people and their different corporate cultures, the process may turn out
to be a disaster.
➢ Integration Difficulties
• Companies very often face integration difficulties, i.e. the combined entity has to
adapt to a new set of challengers given the changed circumstances.
• To do this, the companies prepare plans to integrate the operations of the
combining entities.
• If the information available on related issues is inadequate or inaccurate,
integration becomes difficult.
An acquirer needs to have a workable and clear plan to address problems due to
differences in management styles, incompatibilities in data information systems and
continued opposition to the acquisition by some of the acquired entity’s staff.
44
Why mergers and acquisitions fail?
➢ Lack of industrial or commercial fit
• Failure can result from a horizontal or vertical takeover where the acquired entity
turns out not to have the product range or industrial position that the acquirer
anticipated.
➢ Inadequate Due Diligence
• Due diligence is a crucial component of M&A process as it helps detecting financial
and business risks that the acquirer inherits from the target company.
• Inaccurate estimated of the related risk can result in failure of the merger.
➢ High Leverage
• One of the most crucial elements of an effective acquisition strategy is planning
how one intents to finance the deal through an ideal capital structure.
• The acquirer may decide to acquire the target through cash. To pay the price of the
acquisition, the acquirer my borrow heavily from the market.
45
Exercise: Merger Value and Cost
Question:
Consider the following information for two all-equity firms, Firm A and Firm B:
Firm A Firm B
Shares outstanding 2,000 6,000
Price per share $40 $30
Firm A estimates that the value of the synergistic benefit from acquiring Firm B is
$6,000. Firm B has indicated that it would accept a cash purchase offer of $35 per
share. Should Firm A proceed?
Answer:
The total value of Firm B to Firm A is the premerger value of Firm B plus the $6,000
gain from the merger.
The premerger value of Firm B is $30 x 6,000 = $180,000, so the total value is
$186,000.
At $35 per share, Firm A is paying $35 x 6,000 = $210,000; the merger therefore has a
negative NPV of $186,000 - $210,000 = -$24,000
At $35 per share, Firm B is not an attractive merger partner.
46
Exercise: Stock Mergers and EPS
Question:
Consider the following information for two all-equity firms, Firm A and Firm B:
Firm A Firm B
Total earnings $3,000 $1,100
Shares outstanding 600 400
Price per share $70 $15
P/E 14 5.45
Firm A is acquiring Firm B by exchanging 100 of its shares for all shares in Firm
B.
a)What is the cost of merger if the merged firm is worth $63,000?
b)What will happen to Firm A’s EPS?
c)Its PE ratio?
47
Exercise: Stock Mergers and EPS
Answer:
a) Cost of merger
After the merger, the firm will have 700 shares outstanding.
Because the total value if $63,000, the price per share is $63,000/700 = $90, up from
$70.
Because Firm B’s stockholders end up with 100 shares in the merged firm, the cost of
merger is 100 x $90 = $9,000, not 100 x $70 = $7,000.
b) EPS
Also, the combined firm will have $3,000 + $1,100 = $4,100 in earnings, so EPS will be
$4,100/700 = $5.86, up from $3,000/600 = $5.00
c) PE ratio
The old PE ratio was $70/$5 = 14.00
The new one is $90/$5.86 = 15.37
48
49
Exercise: Cash versus Stock Payment
Question:
Company A is analyzing the possible acquisition of Company B.
Both firms have no debt.
Company A believes the acquisition will increase its total after-tax annual cash flows
by $2.4 million indefinitely.
The current market value of Company A is $107 million and that of Company B is $58
million.
The appropriate discount rate for the incremental cash flows is 10%.
Company A is trying to decide whether it should offer:
i. $73 million in cash to Company B’s shareholders.
ii. 40% percent of its stock or
a) What is the cost of each alternative?
b) What is the NPV of each alternative?
c) Which alternative should Company A choose?
d) Which alternative should Company B choose?
50
Exercise: Cash versus Stock Payment
Answer:
(a)
i. The cash cost is the amount of cash offered, so the cash cost is $73 million.
ii. To calculate the cost of the stock offer, we first need to calculate the value
of the target to the acquirer.
• The value of the target firm to the acquiring firm will be :
− the market value of the target plus
− the PV of the incremental cash flows generated by the target firm.
• The cash flows are a perpetuity, so
• V* = $58,000,000 + $2,400,000/0.10 = $82,000,000
• The cost of the stock offer is the percentage of the acquiring firm given up
times the sum of the market value of the acquiring firm and the value of
the target firm to the acquiring firm. So, the equity cost will be:
• Equity cost = 0.40($107,000,000 + $82,000,000) = $75,600,000
51
Exercise: Cash versus Stock Payment
(b)
• The NPV of each offer is the value of the target firm to the acquiring firm
minus the cost of acquisition, so:
• NPV cash = $82,000,000 – $73,000,000 = $9,000,000
• NPV stock = $82,000,000 – $75,600,000 = $6,400,000
(c)
• For Company A, since the NPV is greater with the cash offer the acquisition
should be in cash.
(d)
• Company B’s shareholder should choose stock offer as it has a higher value.
52
Exercise: Cash versus Stock Payment
• Consider the following premerger information about a bidding firm (Firm B) and a
target firm (Firm T).
• Assume that both firms have no debt outstanding.
• Firm B has estimated that the value of the synergistic benefits from acquiring Firm T
is $6,000.
a) If Firm T is willing to be acquired for $20.5 per share in cash, what is the NPV of the
merger?
b) What will be the price per share of the merged firm be assuming the condition in
(a)?
c) In part (a), what is the merger premium?
d) Suppose Firm T is agreeable to a merger by an exchange of stock. If B offers 1 of its
share for every 2 of T’s shares, what will be the price per share of the merged firm
be?
e) What is the NPV of the merger assuming the condition in (d)?
f) Which alternative should target firm T choose?
53
Exercise: Cash versus Stock Payment
a) The NPV of the merger is the market value of the target firm, plus the
value of the synergy, minus the acquisition costs, so:
• NPV = 1,500($18) + $6,000 – 1,500($20.50) = $2,250
b) Since the NPV goes directly to stockholders, the share price of the merged
firm will be the market value of the acquiring firm plus the NPV of the
acquisition, divided by the number of shares outstanding, so:
• Share price = [3,400($43) + $2,250]/3,400 = $43.66
c) The merger premium is the premium per share times the number of shares
of the target firm outstanding, so the merger premium is:
• Merger premium = 1,500($20.50 – $18) = $3,750
54
Exercise: Cash versus Stock Payment
d) The number of new shares will be the number of shares of the target times
the exchange ratio, so:
• New shares created = 1,500(1/2) = 750 new shares
• The value of the merged firm will be the market value of the acquirer plus
the market value of the target plus the synergy benefits, so:
• VBT = 3,400($43) + 1,500($18) + $6,000 = $179,200
• The price per share of the merged firm will be the value of the merged firm
divided by the total shares of the new firm, which is:
• P = $179,200/(3,400 + 750) = $43.18
55
Exercise: Cash versus Stock Payment
e) The NPV of the acquisition using a share exchange is the market value of the target
firm plus synergy benefits, minus the cost. The cost is the value per share of the
merged firm times the number of shares offered to the target firm shareholders, so:
• NPV = 1,500($18) + $6,000 – 750($43.18) = $614.46
f) The share offer is better given that the target firm shareholders receive $20.5 per
share under cash offer.
• In the share offer, the target firm’s shareholders will receive Equity offer value =
(1/2)($43.18) = $21.59 per share.
• The shareholders of the target firm would prefer the share offer.
Financial Decision Making
Learning Objectives Outline
• -
2
Merger &
Acquisition
3 Legal
procedures of
Acquisition
3 Types of
Acquisition
Valuation of
Synergy benefits
from Acquisition
Synergy benefits:
4 main sources
Financing for
Acquisition
By Cash offer
By Share offer
Dubious reasons:
EPS growth &
Diversification
Divestitures &
Corporate
Restructuring
4 Types of
Divestitures
Reasons for
Divestitures
Reasons for failure
Acquisition
Defensive Tactics
Takeovers – The Market for Corporate Control
There are 3 ways to change the management control of a firm.
These are:
a)Acquisition: The purchase of one firm by another in a merger or acquisition
b)Proxy Contest: This is an attempt to gain control of a firm by soliciting enough
stockholder votes to replace existing management
c)Going Private (Leverage buyout): A leverage buyout of a firm by a private group of
investors (When this group is led by the company’s management, the acquisition is
called a management buyout MBO)
3
Mergers and Acquisitions
Three basic legal procedures one firm can use to acquire another firm:
1. Merger or consolidation
2. Acquisition of stock
3. Acquisition of assets
These forms are different from a legal standpoint, but the financial press
frequently does not distinguish between them
• Merger is often used regardless of actual form of the acquisition
• Acquiring firm is referred to as the bidder, the company that offers to
distribute cash or securities to obtain the stock or assets of another
company
• Firm that is sought (and perhaps acquired) is called the target firm
• Cash or securities offered to the target firm are the consideration in
the acquisition
4
Mergers and Acquisitions
Merger is the complete absorption of one company by another, wherein the acquiring
firm retains its identity and the acquired firm ceases to exist as a separate entity. The
bidder remains and the target ceases to exist.
Consolidation is a merger in which an entirely new firm is created and both the
acquired firm and the acquiring firm cease to exist. A new firm is created. Joined firms
cease their previous existence.
The rules for mergers and consolidation ae basically the same. Acquisition by merger
or consolidation results in a combination of the assets and liabilities of acquired and
acquiring firms; the only difference lies in whether or not a new firm is created.
5
Company A
Company B
Company A
Company B ceases to exist
Company A
Company B
Company C
Company A & B no longer exist
Mergers and Acquisitions
Some advantages and some disadvantages of using a merger:
Primary advantage is that a merger is legally simple and does not cost as
much as other forms of acquisition
• Firms agree to combine their entire operations, so there is no need to
transfer title to individual assets of the acquired firm to the acquiring firm
Primary disadvantage is that a merger must be approved by a vote of the
stockholders of each firm
• Typically, two-thirds (or more) of the share votes are required for approval
and obtaining the necessary votes can be time-consuming and difficult.
6
Acquisition of stock
Another way to acquire another firm is to purchase the firm’s voting stock
with an exchange of cash, shares of stock, or other securities
Process will often start as private offer from management of one firm to that
of another.
Tender offer is a public offer by one firm to directly buy the shares of
another firm
• Communicated to the target firm’s shareholders by public
announcements such as those made in newspaper advertisements
• Tender offer is frequently contingent on the bidder’s obtaining some
percentage of the total voting shares
• Shareholders who choose to accept the offer tender their shares by
exchanging them for cash or securities (or both), depending on the offer
7
Acquisition of stock
Some factors involved in choosing between an acquisition by stock and a
merger:
• In an acquisition by stock, no shareholder meetings must be held and no
vote is required
− If the shareholders of the target firm don’t like the offer, they are not
required to accept it and need not tender their shares
• In an acquisition by stock, the bidding firm can deal directly with the
shareholders of the target firm by using a tender offer
• Acquisition is occasionally unfriendly.
− In such cases, a stock acquisition is used to circumvent the target firm’s
management, which is usually actively resisting acquisition
• Frequently, a significant minority of shareholders will hold out in a tender
offer; target firm cannot be completely absorbed when this happens, and
this may delay realization of merger benefits or be costly in some other way
• Complete absorption of one firm by another requires a merger
8
Acquisition of assets
A firm can effectively acquire another firm by buying most or all of its assets
• Target firm will not necessarily cease to exist; it will have just sold off
its assets
• “Shell” will still exist unless its stockholders choose to dissolve it
This type of acquisition requires a formal vote of the shareholders of the
selling firm
• Advantage to this approach is that there is no problem with minority
shareholders holding out
• Disadvantage is that the acquisition of assets may involve transferring
titles to individual assets, and the legal process of transferring assets
can be costly
9
Types of Acquisition
Financial analysts typically classify acquisitions into three types:
1. Horizontal acquisition is an acquisition of a firm in the same industry
as the bidder
• One risk in a horizontal merger is antitrust regulations
2. Vertical acquisition involves firms at different steps of the production
process
3. Conglomerate acquisition occurs when the bidder and the target
firm are in unrelated lines of business
• Popular in the technology area
Firms don’t have to merge to combine their efforts
• Strategic alliance is an agreement between firms to cooperate in
pursuit of a joint goal
• Joint venture is typically an agreement between firms to create a
separate, co-owned entity established to pursue a joint goal
10
A diagram illustrating horizontal integration and contrasting it with
vertical integration.
11
Forward vertical integration when it
controls distribution centers and retailers
where its products are sold.
Backward vertical integration when it
controls subsidiaries that produce some
of the inputs used in the production of its
products.
A diagram illustrating horizontal integration and contrasting it
with vertical integration.
Types of Acquisition
Questions:
Are the following hypothetical mergers horizontal, vertical or conglomerate?
a) IBM acquires the computer manufacturer Lenovo
Horizontal merger. IBM is in the same industry as Lenovo
b) Lenovo acquires Safeway ( a supermarket chain)
Conglomerate merger. Lenovo and Safeway are in different industries.
c) Safeway acquires Campbell Soup
Vertical merger. Safeway is expanding backward to acquire one of its suppliers, Campbell
Soup.
d) Campbell Soup acquires IBM.
Conglomerate merger. Campbell and IBM are in different industries.
12
13
Why might mergers and acquisitions be beneficial?
Synergy Effect ?
• The whole is worth more than the sum of the parts
• Some mergers create synergies because the firm can either cut costs
or use the combined assets more effectively
• This is generally a good reason for a merger
Examine whether the synergies can create enough benefit to justify
the cost for the following 4 basic categories.
a) Revenue enhancement
b) Cost reduction
c) Lower taxes
d) Reduction in capital needed
Synergy
Suppose Firm A is contemplating acquiring Firm B
• Successful merger requires value of the whole (i.e., combined firm) exceed
the sum of the parts (i.e., values of separate firms)
If VAB is the value of the merged firm, and VA and VB are the values of the
separate firms, the merger makes sense only if:
➢VAB > VA + VB (The whole is more than the sum of the parts)
Difference between the value of the combined firm and the sum of the values
of the firms as separate entities is the incremental net gain from the
acquisition, ΔV:
➢ΔV = VAB − (VA + VB)
Synergy is the positive incremental net gain associated with the combination
of two firms through a merger or acquisition
• When ΔV is positive, the acquisition is said to generate synergy
14
Synergy
If Firm A buys Firm B, it gets a company worth VB plus the incremental gain,
ΔV, so the value of Firm B to Firm A (VB
*) is:
Value of Firm B to Firm A (Acquiring firm) = VB
* = ΔV + VB
VB
* can be determined in two steps:
1. Estimating VB
2. Estimating ΔV
If B is a public company, its market value as an independent firm under
existing management (VB) can be observed directly, but if Firm B is not
publicly owned, its value will have to be estimated based on similar
companies that are publicly owned
15
Synergy
To determine the incremental value of an acquisition, we need to know the
incremental cash flows, ΔCF, the cash flows for the combined firm less what A
and B could generate separately:
ΔCF = ΔRevenue − ΔCost − ΔTax − ΔCapital requirements
Merger will make sense only if one or more of these cash flow components
are beneficially affected by the merger.
Possible cash flow benefits of mergers and acquisitions fall into four basic
categories:
a) Revenue enhancement
b) Cost reductions
c) Lower taxes
d) Reductions in capital needs
16
P/L
B/S
Revenue Enhancement
Marketing gains might occur as a result of improvements in the following areas as a
result of changes in advertising efforts, changes in the distribution network, changes
in the product mix.
a) Previously ineffective media programming and advertising efforts
b) A weak existing distribution network
c) An unbalanced product mix
Strategic benefits are opportunities to take advantage of the competitive environment
if certain things occur or, more generally, to enhance management flexibility with
regard to the company’s future operations
• Beachheads – acquisitions that allow a firm to enter a new industry that may
become a platform for further expansion
Increases in market power (reduction in competition or increase in market share) may
result in profit enhancements through higher prices.
• Mergers that substantially reduce competition may be challenged by U.S.
Department of Justice or Federal Trade Commission on antitrust grounds
17
Cost Reductions
Economies of scale relate to the average cost per unit of producing goods and services
• Ability to produce larger quantities while reducing the average per unit cost
• Most common in industries that have high fixed costs
• Spreading overhead refers to sharing central facilities such as corporate
headquarters, top management, and computer services
Economies of vertical integration have a main purpose of making it easier to
coordinate closely related operating activities
• Coordinate operations more effectively
• Reduced search cost for suppliers or customers
• For example, most forest product firms that cut timber also own sawmills and
hauling equipment
Complementary resources are characterized by some firms acquiring others to make
better use of existing resources or to provide the missing ingredient for success
• For example, a ski equipment store may merge with a tennis equipment store
to produce more even sales over both the winter and summer seasons,
thereby better using store capacity
• Anther example: banks that allow insurance or stock brokerage services to be
sold on premises
18
Lower Taxes
Possible tax gains from an acquisition include the following:
a) Take advantage of net operating losses
− Carry-backs and carry-forwards
− Merger may be prevented if the tax authorities believe the sole purpose is
to avoid taxes
b) Unused debt capacity
− Allows merged firms to borrow more giving rise to tax shields
c) Surplus funds
− Under free cash flow, firms are encouraged to pay dividends to remove the
free cash from the firm. This method may result in shareholders having to
pay more taxes. Using the excess cash for acquisitions avoids having to pay
additional taxes.
• Net operating losses (NOL) are tax losses a firm cannot use because they
lost money on a pretax basis (and will not pay taxes)
19
Reductions in Capital needs
All firms must invest in working capital and fixed assets to sustain an efficient
level of operating activity
‒ A merger may reduce the required investment in working capital and fixed
assets relative to the two firms operating separately
Acquiring firms may be able to manage existing assets more effectively under
one umbrella
‒ Can occur with a reduction in working capital resulting from more efficient
handling of cash, accounts receivable, and inventory
Acquiring firm may also sell off certain assets that are not needed in the
combined firm
‒ Some assets may be sold if they are redundant in the combined firm (this
includes reducing human capital as well)
20
Analytical income statement
Sales
- Total variable costs
- Fixed costs
EBIT (Operating income)
- Interest
EBT
- Taxes
Net income
21
Revenue Enhancement
Cost
Reductions
Lower Taxes
Dubious reason for EPS Growth
• Mergers and acquisition may give the appearance of growth in EPS without
actually changing cash flows.
• Buying a firm with a lower P/E ratio can increase earnings per share. But the
increase should not result in a higher share price.
• If there are no synergies or other benefits to the merger, then the growth in EPS is
not true growth.
• Example:
• Suppose Global Resources, Ltd., acquires Regional Enterprises, but the merger
creates no additional value; after the merger we should have the following
information if the market is smart.
• Global will have 140 shares outstanding
• Market value of the combined firm is $3,500
• Earnings per share of the merged firm are $1.43
• Because the stock price of Global after the merger is the same as before the
merger, the price-earnings ratio must fall.
22
Dubious reason for EPS Growth
Acquisition can create appearance of EPS growth
• Suppose Global Resources, Ltd., acquires Regional Enterprises.
• The financial positions of both firms before the acquisition is shown below.
• Assume the merger creates no additional value, so the combined firm (Global Resources after
acquiring Regional) has a value that is equal to the sum of the values of two firms before the
merger.
• Before the merger, both firms have 100 shares outstanding. However, Global sells for $25 per
share versus a price of $10 per share for Regional.
• Global acquires Regional by exchanging 1 of its share for every 2.5 shares in Regional. Because
there are 100 shares in Regional, this will take 100/2.5 = 40 shares in all.
• After the merger, Global will have 140 shares outstanding and several things will happen.
23
Dubious reason for EPS Growth
The market value of the combined firm is $3,500, that is $2,500 plus $1,000. This is equal to the
sum of the values of these 2 firm before the merger and the price per share $3,500/140 = $25
If the market is “smart”, it will realize that the combined firm is worth the sum of the values of
these 2 separate firms.
The earnings per share of the merged firm is $1.43 ($200/140) and the acquisition enables Global
to increase its earnings per share from $1 to $1.43, an increase of 43 %.
Because the stock price of Global after the merger is the same as before the merger (the merger
creates no additional value), the price-to-earnings ratio must fall to 17.50, that is, $25/$1.43 and
recognizes that the total market value has not been altered by the merger.
24
P/E must fall
$200/140
$3,500/140
$2,500+ $1,000
Dubious reason for EPS Growth
If the market is “fooled”, it might mistake the 43% increase in earnings per share for true growth.
In this case, the PE ratio of Global may not fall after the merger and remains equal to 25.
Because the combined firm has earnings of $200, the total value of the combined firm will
increase to $5,000 (25 x $200).
The per share value for Global will increase to $35.71 ($5,000/140).
This is earnings growth is illusion only as can be seen, the merger does not create value.
25
Bootstrapping
In the previous example, Global takes over Regional and it is assumed that the post
acquisition value of the combined company can be estimated by applying Global’s P/E
ratio to be combined company’s earnings.
This is known as bootstrapping and it is based on that the market will assume that the
management of the acquiring company will be able to apply common approach to
both companies after the takeover, thus improving the performance of the acquired
company by using the methods that they have been using on their own company
before the takeover.
26
Dubious reason for Diversification
• Diversification is commonly mentioned as a benefit of a merger, but
diversification is not a good reason for a merger because:
• Diversification doesn’t create value itself because diversification reduces
unsystematic, not systematic risk.
• Value of an asset depends on its systematic risk, and systematic risk is
not directly affected by diversification
• Because the unsystematic risk is not especially important, there is no
particular benefit from reducing it
• Stockholders can get all the diversification they want by buying stock in
different companies. They can diversify their own portfolio more cheaply
than a firm can diversify by acquisition.
• As a result, they won’t pay a premium for a merged company for the
benefit of diversification
• Reducing unsystematic risk benefits bondholders by making default less
likely.
27
The Cost of an Acquisition by Cash and Stock
We learned earlier the net incremental gain from a merger is:
ΔV = VAB − (VA + VB)
Total value of Firm B to Firm A, VB
*, is:
VB
*= VB + ΔV
Net present value (NPV) of the merger is:
NPV = VB
*− Cost to Firm A of the acquisition
Suppose the premerger information below applies for Firms A and B:
• Both of these firms are 100% equity
• You estimate the incremental value of the acquisition, ΔV, is $100
• Board of Firm B has indicated that it will agree to a sale if the price is $150, payable
in cash or stock
28
The cost of an acquisition: Cash acquisition
Should Firm A acquire Firm B? Should it pay in cash or stock?
Value of Firm B to Firm A is:
VB
* = ΔV + VB
= $100 + $100 = $200
If Firm A pays $150 in cash to purchase all the shares of Firm B, the cost of acquiring
Firm B is $150 and the NPV of a cash acquisition is:
NPV = VB
* − Cost
= $200 − $150 = $50
After the merger, Firm AB will still have 25 shares outstanding
Value of Firm A after the merger is:
VAB = VA + (VB
*− Cost)
= $500 + $200 − $150
= $550
Price per share after merger is $550/25 = $22, representing a gain of $2 per share
29
The cost of an acquisition: Stock acquisition
Value of merged firm in this case will equal the premerger values of Firms A and B plus
the incremental gain from the merger, ΔV:
VAB = VA + VB + ΔV
= $500 + $100 + $100
= $700
To give $150 worth of stock for Firm B, Firm A will have to give up $150/$20 = 7.5
shares
After the merger, there will be 25 + 7.5 = 32.5 shares outstanding, and the per share
value will be $700/32.5 = $21.54
Total value of consideration received by B’s stockholders is 7.5 × $21.54 = $161.54
NPV of the merger to Firm A is:
NPV = VB
* − Cost
= $200 − $161.54 = $38.46
Cash acquisition (from previous slide) is better in this case for Company A (the
acquirer).
30
31
Stock Acquisition
• Evaluating the terms of a merger can be tricky when there is an exchange of
shares as the cost of acquisition:
• Depends on the number of shares given to the target stockholders
• Depends on the price of the combined firm’s stock after the merger
Acquisition by Cash and Stock (Example)
Acquiring Food Company is considering acquisition of a smaller company, Target Food
Company.
Acquiring Food Company is proposing to finance the deal by purchasing all of Target’s
outstanding stock for $19 per share.
Some financial information for these 2 companies is given below.
Cost of capital is 20%.
32
Acquisition by Cash and Stock (Example)
a) Why would Acquiring Food and Target Food be worth more together than apart?
As can be see, the operating costs can be reduced by combining the companies’
marketing, distribution and administration by $2 million per year.
Revenue can also be increased in Target Food’s region by another $2 million per year.
The earnings for the two firms operating together will increase projected earnings by
$4 million.
Assuming this increased earnings are the only synergy to be generated by the merger.
The economic gain to the merger is the present value of the extra earnings.
If the earnings increase in permanent ( a perpetuity) and the cost of capital is 20%.
The present value of synergy (economic gain) is $4 million / 0.2 = $20 million
33
Acquisition by Cash and Stock (Example)
b) What is the cost of acquisition to Acquiring Food Company by cash?
• In this case, it is a cash offer of $19 per share and $3 per share over the current
market price ($16).
• Target Food has 2.5 million outstanding shares and Acquiring Food has to pay a
premium of $3 x 2.5 million = $7.5 million over Target’s market value.
• Target shareholders will capture $7.5 million out of $20 million gain form the
merger, leaving $12.5 million gain to Acquiring shareholders.
NPV cash to Acquiring Food
= Value of Target Food + PV of Synergy – Cost paid to Target Food
= $16 x 2.5 million + $20 million - $19 x 2.5 million
= $40 million + $20 million - $47.5 million
= $12.5 million
34
Acquisition by Cash and Stock (Example)
c) What is the cost of acquisition to Acquiring Food Company by stock?
Suppose Acquiring Food would like to conserve cash and elect to pay Target Food
shareholder by stock.
The deal call for Target Food shareholders to receive 1 Acquiring Food for every 3
shares of Target Food.
In this case, 2.5 million Target shares will result in issue of 2.5 million / 3 = 0.833
million shares of Acquiring Food.
That means after the acquisition, there will be 10 million + 0.833 million = 10.833
million of shares in the merged firm.
Total value of merged firm
= Value of Acquiring Food + Value of Target Food + PV of Synergy
= $48 x 10M + $16 x 2.5M + $20M =$480M + $40M + $20M
= $540M
Share price after merger = $540M / 10.833M = $49.85
35
Acquisition by Cash and Stock (Example)
The value of shares given to Target’s original shareholders is 0.833 million x $49.85 =
$41.5 million
NPV stock to Acquiring Food
= Value of Target Food + PV of Synergy – Value of shares paid to Target
= $16 x 2.5 million + $20 million – $49.85 x 0.833 million
= $40M + $20M + 41.5M
= $18.5M
This is higher than cash offer $12.5M and therefore, share offer is better than cash
offer for Acquiring Food Company.
There is a key distinction between cash and stock offer for financing mergers.
If cash is offered, the cost of merger is not affected by the size of the merger gains.
If stock is offered, the cost depends on the gains because the gains show up in the
post merger share price, and these shares are used to pay for the acquired firm.
36
Acquisition by Cash and Stock (Example)
Suppose Target Food shareholders demand 1 Acquiring share for every 2.5 Target Food
shares. Otherwise, they will not accept the offer.
Under these revised terms, is the merger still a good deal for Acquiring Food?
In this case, 2.5 million Target shares will result in issue of 2.5 million / 2.5 = 1 million
shares of Acquiring Food.
That means after the acquisition, there will be 10 million + 1 million = 11 million of
shares in the merged firm.
Total value of merged firm remains the same as:
= Value of Acquiring Food + Value of Target Food + PV of Synergy
= $48 x 10M + $16 x 2.5M + $20M =$480M + $40M + $20M
= $540M
Share price after merger = $540M / 11 = $49.09
37
Acquisition by Cash and Stock (Example)
The value of shares given to Target’s original shareholders is 1 million x $49.09 =
$49.09 million
NPV stock to Acquiring Food
= Value of Target Food + PV of Synergy – Value of shares paid to Target
= $16 x 2.5 million + $20 million – $49.09 x 1 million
= $40M + $20M - 49.09M
= $10.91M
This is positive and therefore, Acquiring Food Inc. should accept it.
In this case, cash offer $12.5M is better then share offer $10.91M from Acquiring Food
Inc.’s position.
38
39
Cash versus Common Stock
Distinction between cash and common stock financing in a merger is an important
one
• If using cash, cost of acquisition is not dependent on acquisition gains
• All else equal, if common stock is used, cost is higher because Firm A’s
shareholders (acquiring firm) must share acquisition gains with shareholders of
Firm B (target company)
Whether a firm should finance an acquisition with cash or with shares of stock
depends on several factors, including the following:
Considerations when choosing between cash and stock
a) Sharing gains: If cash is used to finance an acquisition, selling firm’s
shareholders will not participate in potential gains from the merger
b) Taxes: Acquisition by paying cash often results in taxable transaction, while
acquisition by exchanging stock is usually tax-free
c) Control: Acquisition by paying cash does not affect control of acquiring firm,
while acquisition with voting shares may have implications for control of
merged firm
Typically, cash financing is more common than stock financing
Cash versus Common Stock
• Because of asymmetric information, the acquiring firm knows best the true value of
its own stock
• If the acquiring firm thinks that its own stock is overvalued, it has an incentive to
pay with stock, since the target firm’s shareholders would be getting less than the
stock price suggests (this assumes that in the long run, the market will correct itself
and the price will fall)
40
Cash and Share offer: Advantages and Disadvantages
In a cash offer, the target company shareholders are offered a fixed cash sum per
share.
➢ Advantages
• When the bidder has sufficient cash the takeover can be achieved quickly at low
cost.
• Target company shareholders have certainty about the bid’s value i.e. there is less
risk compared to accepting shares in the bidding company.
• There is increased liquidity to target company shareholders, i.e. accepting cash in a
takeover, is a good way of realizing an investment.
• The acceptable consideration is likely to be less than with a share exchange as there
is less risk to target company shareholders. This reduces the overall cost of the bid
to the bidding company.
➢ Disadvantages
• With larger acquisition the bidder must often borrow in the capital markets or issue
shares in order to raise the cash. This may have an adverse effect on gearing and
also cost of capital due to the increased financial risk.
• For target company shareholders, this is a taxable gain for cash received.
• Target company shareholders may be unhappy with a cash offer because they
cannot participate in the new company.
41
Cash and Share offer: Advantages and Disadvantages
In a share exchange, the bidding company issues some new shares and then
exchanges them with the target company shareholders.
➢ Advantages
• The bidding company does not have to raise cash to make the payment
• Shareholder capital is increased and gearing similarly improved as the shareholders
of the acquired company become shareholders in the post acquisition (merged)
company.
• A share exchange can be used to finance very large acquisitions.
• The gain due to share exchange is not taxable transaction.
➢ Disadvantages
• The bidding company’s shareholders have to share future gains with the acquired
entity and the current shareholders will have a lower proportionate control and
share in profits of the combined entity than before.
• Price risk – there is price risk that the market price of the bidding company’s shares
will fall during the bidding process which may result in the bid failing
• For example, if a 1 or 2 share exchange is offered based on the fact that the bidding
company’s shares are worth approximately double the value of the target
company’s shares, the bid might fail if the value of the bidding company’s shares
falls before the acceptance date.
42
Why mergers and acquisitions fail?
➢ Unrealistic Price Paid for target (Paying too much)
• The process of M&A involves valuation of the target company and paying a price for
taking over the assets of the company.
• Quite often, one finds that the price paid to the target company is much more than
what should have been paid
• While the shareholders of the target company stand benefited the shareholders of
the acquired end up on the losing side.
➢ Overstated Synergies
• Mergers and acquisitions are looked upon as an important instrument of creating
synergies through increased revenue, reduced costs, reduction in working capital
and improvements in the investment intensity.
• Overestimated of these can lead to failures of mergers and acquisitions.
43
Why mergers and acquisitions fail?
➢ Difficulties in Cultural Integration
• Every merger involves combining of two or more different entities.
• These entities reflect corporate cultures, styles of leadership, differing employee
expectations and functional differences.
• If the merger is implemented in a way that does not deal sensitivity with the
companies’ people and their different corporate cultures, the process may turn out
to be a disaster.
➢ Integration Difficulties
• Companies very often face integration difficulties, i.e. the combined entity has to
adapt to a new set of challengers given the changed circumstances.
• To do this, the companies prepare plans to integrate the operations of the
combining entities.
• If the information available on related issues is inadequate or inaccurate,
integration becomes difficult.
An acquirer needs to have a workable and clear plan to address problems due to
differences in management styles, incompatibilities in data information systems and
continued opposition to the acquisition by some of the acquired entity’s staff.
44
Why mergers and acquisitions fail?
➢ Lack of industrial or commercial fit
• Failure can result from a horizontal or vertical takeover where the acquired entity
turns out not to have the product range or industrial position that the acquirer
anticipated.
➢ Inadequate Due Diligence
• Due diligence is a crucial component of M&A process as it helps detecting financial
and business risks that the acquirer inherits from the target company.
• Inaccurate estimated of the related risk can result in failure of the merger.
➢ High Leverage
• One of the most crucial elements of an effective acquisition strategy is planning
how one intents to finance the deal through an ideal capital structure.
• The acquirer may decide to acquire the target through cash. To pay the price of the
acquisition, the acquirer my borrow heavily from the market.
45
Exercise: Merger Value and Cost
Question:
Consider the following information for two all-equity firms, Firm A and Firm B:
Firm A Firm B
Shares outstanding 2,000 6,000
Price per share $40 $30
Firm A estimates that the value of the synergistic benefit from acquiring Firm B is
$6,000. Firm B has indicated that it would accept a cash purchase offer of $35 per
share. Should Firm A proceed?
Answer:
The total value of Firm B to Firm A is the premerger value of Firm B plus the $6,000
gain from the merger.
The premerger value of Firm B is $30 x 6,000 = $180,000, so the total value is
$186,000.
At $35 per share, Firm A is paying $35 x 6,000 = $210,000; the merger therefore has a
negative NPV of $186,000 - $210,000 = -$24,000
At $35 per share, Firm B is not an attractive merger partner.
46
Exercise: Stock Mergers and EPS
Question:
Consider the following information for two all-equity firms, Firm A and Firm B:
Firm A Firm B
Total earnings $3,000 $1,100
Shares outstanding 600 400
Price per share $70 $15
P/E 14 5.45
Firm A is acquiring Firm B by exchanging 100 of its shares for all shares in Firm
B.
a)What is the cost of merger if the merged firm is worth $63,000?
b)What will happen to Firm A’s EPS?
c)Its PE ratio?
47
Exercise: Stock Mergers and EPS
Answer:
a) Cost of merger
After the merger, the firm will have 700 shares outstanding.
Because the total value if $63,000, the price per share is $63,000/700 = $90, up from
$70.
Because Firm B’s stockholders end up with 100 shares in the merged firm, the cost of
merger is 100 x $90 = $9,000, not 100 x $70 = $7,000.
b) EPS
Also, the combined firm will have $3,000 + $1,100 = $4,100 in earnings, so EPS will be
$4,100/700 = $5.86, up from $3,000/600 = $5.00
c) PE ratio
The old PE ratio was $70/$5 = 14.00
The new one is $90/$5.86 = 15.37
48
49
Exercise: Cash versus Stock Payment
Question:
Company A is analyzing the possible acquisition of Company B.
Both firms have no debt.
Company A believes the acquisition will increase its total after-tax annual cash flows
by $2.4 million indefinitely.
The current market value of Company A is $107 million and that of Company B is $58
million.
The appropriate discount rate for the incremental cash flows is 10%.
Company A is trying to decide whether it should offer:
i. $73 million in cash to Company B’s shareholders.
ii. 40% percent of its stock or
a) What is the cost of each alternative?
b) What is the NPV of each alternative?
c) Which alternative should Company A choose?
d) Which alternative should Company B choose?
50
Exercise: Cash versus Stock Payment
Answer:
(a)
i. The cash cost is the amount of cash offered, so the cash cost is $73 million.
ii. To calculate the cost of the stock offer, we first need to calculate the value
of the target to the acquirer.
• The value of the target firm to the acquiring firm will be :
− the market value of the target plus
− the PV of the incremental cash flows generated by the target firm.
• The cash flows are a perpetuity, so
• V* = $58,000,000 + $2,400,000/0.10 = $82,000,000
• The cost of the stock offer is the percentage of the acquiring firm given up
times the sum of the market value of the acquiring firm and the value of
the target firm to the acquiring firm. So, the equity cost will be:
• Equity cost = 0.40($107,000,000 + $82,000,000) = $75,600,000
51
Exercise: Cash versus Stock Payment
(b)
• The NPV of each offer is the value of the target firm to the acquiring firm
minus the cost of acquisition, so:
• NPV cash = $82,000,000 – $73,000,000 = $9,000,000
• NPV stock = $82,000,000 – $75,600,000 = $6,400,000
(c)
• For Company A, since the NPV is greater with the cash offer the acquisition
should be in cash.
(d)
• Company B’s shareholder should choose stock offer as it has a higher value.
52
Exercise: Cash versus Stock Payment
• Consider the following premerger information about a bidding firm (Firm B) and a
target firm (Firm T).
• Assume that both firms have no debt outstanding.
• Firm B has estimated that the value of the synergistic benefits from acquiring Firm T
is $6,000.
a) If Firm T is willing to be acquired for $20.5 per share in cash, what is the NPV of the
merger?
b) What will be the price per share of the merged firm be assuming the condition in
(a)?
c) In part (a), what is the merger premium?
d) Suppose Firm T is agreeable to a merger by an exchange of stock. If B offers 1 of its
share for every 2 of T’s shares, what will be the price per share of the merged firm
be?
e) What is the NPV of the merger assuming the condition in (d)?
f) Which alternative should target firm T choose?
53
Exercise: Cash versus Stock Payment
a) The NPV of the merger is the market value of the target firm, plus the
value of the synergy, minus the acquisition costs, so:
• NPV = 1,500($18) + $6,000 – 1,500($20.50) = $2,250
b) Since the NPV goes directly to stockholders, the share price of the merged
firm will be the market value of the acquiring firm plus the NPV of the
acquisition, divided by the number of shares outstanding, so:
• Share price = [3,400($43) + $2,250]/3,400 = $43.66
c) The merger premium is the premium per share times the number of shares
of the target firm outstanding, so the merger premium is:
• Merger premium = 1,500($20.50 – $18) = $3,750
54
Exercise: Cash versus Stock Payment
d) The number of new shares will be the number of shares of the target times
the exchange ratio, so:
• New shares created = 1,500(1/2) = 750 new shares
• The value of the merged firm will be the market value of the acquirer plus
the market value of the target plus the synergy benefits, so:
• VBT = 3,400($43) + 1,500($18) + $6,000 = $179,200
• The price per share of the merged firm will be the value of the merged firm
divided by the total shares of the new firm, which is:
• P = $179,200/(3,400 + 750) = $43.18
55
Exercise: Cash versus Stock Payment
e) The NPV of the acquisition using a share exchange is the market value of the target
firm plus synergy benefits, minus the cost. The cost is the value per share of the
merged firm times the number of shares offered to the target firm shareholders, so:
• NPV = 1,500($18) + $6,000 – 750($43.18) = $614.46
f) The share offer is better given that the target firm shareholders receive $20.5 per
share under cash offer.
• In the share offer, the target firm’s shareholders will receive Equity offer value =
(1/2)($43.18) = $21.59 per share.
• The shareholders of the target firm would prefer the share offer.
