Chapter 25
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Chapter 25

Course: AEM 3240, Spring 2008

School: Cornell

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Agreeing to be acquired by another firm is one way that shareholders can remove existing managers. There are three basic legal procedures that one firm can use to acquire another firm: 1. Merger or consolidation. 2. Acquisition of stock. 3. Acquisition of assets. Although these forms are different from a legal standpoint, the financial press frequently does not distinguish between them. The term merger is often...

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to Agreeing be acquired by another firm is one way that shareholders can remove existing managers. There are three basic legal procedures that one firm can use to acquire another firm: 1. Merger or consolidation. 2. Acquisition of stock. 3. Acquisition of assets. Although these forms are different from a legal standpoint, the financial press frequently does not distinguish between them. The term merger is often used regardless of the actual form of the acquisition. Merger or Consolidation There are some advantages and some disadvantages to using a merger to acquire a firm: 1. A primary advantage is that a merger is legally simple and does not cost as much as other forms of acquisition. The reason is that the firms simply agree to combine their entire operations. Thus, for example, there is no need to transfer title to individual assets of the acquired firm to the acquiring firm. 2. A primary disadvantage is that a merger must be approved by a vote of the stockholders of each firm Typically, two-thirds (or even more) of the share votes are required for approval. Obtaining the necessary votes can be time-consuming and difficult. Furthermore, as we discuss in greater detail a bit later the cooperation of the target firm's existing management is almost a necessity for a merger. This cooperation may not be easily or cheaply obtained. Acquisition of Stock A second way to acquire another firm is to simply purchase the firm's voting stock with an exchange of cash, shares of stock, or other securities. This process will often start as a private offer from the management of one firm to that of another. In an acquisition by stock, no shareholder meetings have to be held and no vote is required. Resistance by the target firm's management often makes the cost of acquisition by stock higher than the cost of a merger. Acquisition of Assets A firm can effectively acquire another firm by buying most or all of its assets. This accomplishes the same thing as buying the company. In this case, however, the target firm will not necessarily cease to exist; it will have just sold off its assets. The "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. Takeover This can occur through any one of three means: acquisitions, proxy contests, and going-private transactions. Taxes and Acquisitions If one firm buys another firm, the transaction may be taxable or tax-free. ;. In a taxable acquisition, the shareholders of the target firm are considered to have sold their shares, and they will have capital gains or losses that will be taxed. In a tax-free acquisition, the acquisition is considered an exchange instead of a sale, so no capital gain or loss occurs at the time of the transaction. In general, if the buying firm offers the selling firm cash for its equity, it will be a taxable acquisition. If shares of stock are offered, the transaction will generally be a tax-free acquisition. In a tax-free acquisition, the selling shareholders are considered to have exchanged their old shares for new ones of equal value, so that no capital gains or losses are experienced. There are two factors to consider when comparing a tax-free acquisition and a taxable acquisition: the capital gains effect and the write-up effect. This is the write-up effect, and it is important because it means that the depreciation expense on the acquired firm's assets can be increased in taxable acquisitions. The benefit from the write-up effect was sharply curtailed by the Tax Reform Act of 1986. As we just discussed, the purchase method generally leads to the creation of an intangible asset called goodwill. . Pre-2001 guidelines required firms to amortize this goodwill, meaning that a portion of it was deducted as an expense every year over some period of time. In essence, the goodwill, like any asset, had to be depreciated until it was completely written off. The opposite of good will is called ill will. Gs. . As a compromise, in 2001 FASB eliminated the requirement that goodwill be amortized and put in place a new rule. In essence, the new rule says that each year firms must assess the value of the goodwill on their balance sheets. If the value has gone down (or be "impaired" in accounting-speak), the firm must deduct the decrease; otherwise, no amortization is required. Vab = Value of the merged firms. Vab > Va +Vb The merger makes sense only if this happens. V = Vab (Va + Vb) When this is positive we say that this generates SYNERGY Value of Firm B to Firm A = Vb = V + Vb Example 25.1 Firms A and B are competitors with very similar assets and business risks. Both are all-equity firms with aftertax cash flows of $10 per year forever, and both have an overall cost of capital of 10 percent. Firm A is thinking of buying Firm B. The aftertax cash flow from the merged firm would be $21 per year Does the merger generate synergy? What is Vb? What is V? The merger does generate synergy because the cash flow from the merged firm is CF = $1 greater than the sum of the individual cash flows ($21 versus $20). Assuming the risks stay the same, the value of the merged firm is $21/.10 = $210. Firms A and B are each worth $10/.10 = $100, for a total of $200. The incremental gain from the merger, A, Vb is thus $210 200 = $10. The total value of Firm B to Firm A, Vb, is $100 (the value of B as a separate company) plus $10 (the incremental gain), or $110. CF = EBIT + Depreciation Tax Capital Requirement CF= Revenue + Cost Tax Capital Requirements Where revenue, cost, tax and capital requirements are net differences. Revenue Enhancement 1. Marketing Gains. It is frequently claimed that mergers and acquisitions can produce greater operating revenues from improved marketing. 2. Strategic Benefits. This is an opportunity 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. 3. Market Power. One firm may acquire another to increase its market share and market power. Cost Reductions 1. Economies of Scale. Economies of scale relate to the average cost per unit of producing goods and services. Frequently, the phrase spreading overhead is used in connection with economies of scale. 2. Economies of Vertical Integration. Operating economies can be gained from vertical combinations as well as from horizontal combinations. The main purpose of purpose of vertical acquisitions is to make it easier to coordinate closely related operating activities. 3. Complementary Resources: Some firms acquire others to make better use of existing resources or to provide the missing ingredient for success. Think of a ski equipment store that could merge with a tennis equipment store to produce more even sales over both the winter and summer seasons, thereby better using store capacity. Lower Taxes 1. Net Operating Losses: losses they cannot use. These tax losses are referred to as net firms can end up with tax losses they cannot use. These tax losses are referred to as net operating losses (NOL). 2. Surplus Funds: >. Consider a firm that has free cash flow--cash flow available after all taxes have been paid and after all positive net present value projects have been financed. In such a situation, aside from purchasing fixed-income securities, the firm has several ways to spend the free cash flow, including: a. Paying dividends. b. Buying back its own shares. c. Acquiring shares in another firm. We saw that an extra dividend will increase the income tax paid by some investors. A share repurchase will reduce the taxes sole purpose is to avoid taxes paid by shareholders as compared to paying dividends, but this is not a ha legal option if the sole purpose is to avoid taxes that would have otherwise been paid by shareholders. To avoid these problems, the firm can buy another firm. By doing this, the firm avoids the tax problem associated with paying a dividend. Also, the dividends received from the purchased firm are not taxed in a merger. 3. Unused Debt Capacity: Some firms do not use as much debt at as they are able. This makes them potential acquisition candidates. 4. Asset Write Ups: If the value of the assets increases, tax deductions for depreciation will be a benefit; but this benefit will usually be more than offset by taxes due the write-up. Firm A may need to expand its manufacturing facilities, whereas Firm B may have significant excess capacity. It may be much cheaper for Firm A to buy Firm B than to build from scratch. Avoiding Mistakes 1. Do not ignore market values: The current market value represents a consensus of opinion investors concerning the firm's value (under existing management). Use this value as a starting point. 2. Estimate only incremental cashflows: It is important to estimate the incremental casHflows that will result from the acquisition. 3. Use the correct discount rate: The discount rate should be the required rate of return for the incremental cash flows associated with the acquisition. It should reflect the risk associated with the use of funds, not the source. 4. Be aware of transactions costs: : An acquisition may involve substantial (and sometimes astounding) transactions costs. These will include fees to investment bankers, legal fees, and disclosure requirements. There are firms whose value could be increased with a change in management. These are firms that are poorly run or otherwise do not efficiently use their assets to create shareholder value. Mergers are a means of replacing g management in such cases. Before the merger, both Global and Regional have 100 shares outstanding. However, Global sells for $25 per share, versus a price of $ 10 per share for Regional. Global therefore acquires Regional by exchanging 1 of its shares for every 2.5 Regional shares. Because there are 100 shares in Regional, this will take 100/2.5 = 40 shares in all. Previously these firms had $1 earnings per share each. The new earnings per share can be calculated by taking the Price per share divided by the two firm averaged price to earnings ratio. This is not real growth but it can be confused as real growth. Explain to me why the earnings per share multiplied by the P/E ratio will give you the price per share. Diversification is not by itself a good reason for a merger because stockholders are able to do it themselves. In addition, in a horizontal merger, you are not diversifying a portfolio for a stock holder because that industry has already been diversified away. The Cost of an Acquisition The NPV of a merger is therefore. NPV = Vb Cost to Firm A of the acquisition. Firm A $20 25 $500 Firm B $10 10 $100 Price Per Share Number of Shares Total Market Value CASE I : CASH ACQUISITION After a merger, the outstanding stock is the number of the firm buying the other. The stock number does not increase. Verify that the stock price after merger with cash will be $22 CASE II : STOCK ACQUISTION The shareholders of FIRM B want $150 for their company. The V = $100. 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. Verify these numbers. It appears that Firm A paid $150 for Firm B. However, it actually paid more than that. When all is said and done, B's stockholders own 7.5 shares of stock in the merged firm. After the merger, each of these shares is worth $21.54. The total value of the consideration received by B's stockholders is thus 7.5 X $21.54 = $161.55. NPV = Vb Cost = $200- 161.55 = $38.45 Whether a firm should finance an acquisition with cash or with shares of stock depends on several factors, including the following: 1. Sharing gains: If cash is used to finance an acquisition, the selling firm's shareholders will not participate in the potential gains from the merger. Of course, if the acquisition is not a success, the losses will not be shared, and shareholders of the acquiring firm will be worse off than if stock had been used. 2. Taxes: Acquisition by paying cash usually results in a taxable transaction. Acquisition by exchanging stock is generally tax-free. 3. Control: Acquisition with voting shares may have implications for control of the merged firm. Acquisition with voting shares may have implications for control of the merged firm. .With staggered elections, only a fraction of the directorships are up for election at a particular time. Thus if only two directors are up for election at any one time, it will take 1/(2 + 1) = 33.33% of the stock plus one share to guarantee a seat. Staggering makes takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors. This is a classified board. Shared Rights Plans: The rights issued with an SRP have a number of unusual features. In addition, unlike ordinary stock rights, these rights can't be exercised immediately, and they can't be bought and sold separately from the stock. D. Typically, the rights will be triggered when someone acquires 20 percent of the common stock or announces a tender offer. When the rights are triggered, they can be exercised. The flip in provision is then enacted. The flip-in provision is the "poison" in the pill. In the event of an unfriendly takeover attempt, the holder of a right can pay the exercise price and receive common stock in the target firm worth twice the exercise price. In other words, holders of the rights can buy stock in the target firm at half price. Simultaneously, the rights owned by the raider (the acquirer) are voided. The goal of the flip-in provision is to massively dilute the raider's The rights issued p . This greatly increases the cost of the merger to the bidder because the target firm's shareholders end up with a much larger percentage of the merged firm. Going Private & Leveraged Buyouts: A company can go private by debt financing and buying all there shares with the debt. However, this only protects the management because the shareholders are bought out by them. Shareholders in bidder firms seem to neither win nor lose very much, at least on average in the case of an acquisition. The target firms shareholder typically receive a premium and are better off. The premium typically paid by bidders represents an immediate, relatively large gain, often on the order of 20 percent or more. SUMMARY This chapter has introduced you to the extensive literature on mergers and acquisitions. We mentioned a number of issues: 1. Forms of merger: One firm can acquire another in several different ways. The three legal forms of acquisition are merger or consolidation, acquisition of stock and acquisition of assets. 2. Tax issues: Mergers and acquisitions can be taxable or tax-free transactions. The primary issue is whether the target firm's stockholders sell or exchange their shares. Generally, a cash purchase will be a taxable merger, whereas a stock exchange will not be taxable. In a taxable merger, there are capital gains effects and asset write-up effects to consider. In a stock exchange, the target firm's shareholders become shareholders in the merged firm. 3. Accounting issues: Accounting for mergers and acquisitions traditionally involved either the purchase method or the pooling of interests method. In 2001, pooling was eliminated as an option. As a result, a merger or acquisition will generally result in the creation of goodwill; but under the new guidelines, goodwill does not have to be amortized. 4. Merger valuation: If Firm A is acquiring Firm B, the benefits (V) from the acquisition are defined as the value of the combined firm (Vab) less the value of the firms as separate entities [V^ and Vb): V = Vab (Va + Vb) The gain to Firm A from acquiring Firm B is the increased value of the acquired firm, V, plus the value of B as a separate firm, Vb. The total value of Firm B to Firm A, Vb, is thus: Vb= V + Vb An acquisition will benefit the shareholders of the acquiring firm if this value is greater than the cost of the acquisition. The cost of an acquisition can be defined in general terms as the price paid to the shareholders of the acquired firm. The cost frequently includes a merger premium paid to the shareholders of the acquired firm. Moreover, the cost depends on the form of payment--that is, the choice between paying with cash or paying with common stock. 5. Benefits: The possible benefits of an acquisition come from several sources, including the following: a. Revenue enhancement. b. Cost reductions. c. Lower taxes. d. Reductions in capital needs. 6. Defensive tactics: Some of the most colorful language of finance comes from defensive tactics used in acquisition battles. Poison pills, golden parachutes, crown jewels, and greenmail are some of the terms that describe various antitakeover tactics. 7. Effect on shareholders: Mergers and acquisitions have been extensively studied. The basic conclusions are that, on average, the shareholders of target firms do well, whereas the shareholders of bidding firms do not appear to gain much. 8. Divestitures: For a variety of reasons, companies often wish to sell assets or operating units. For relatively large divestitures involving operating units, firms .sometimes elect to do carve-outs, spin-offs, or split-ups.

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