WEEK 11Merger versus ConsolidationMerger ---- One firm is acquired by another--- Acquiring firm retains name and acquired firm ceases to exist--- Advantage – legally simple---- Disadvantage – must be approved by stockholders of both firms. Consolidation Entirely new firm is created from combination of existing firms.Acquisitions : A firm can be acquired by another firm or individual(s) purchasing voting shares of the firm’s stock . Tender offer(off-market) – public offer to buy shares to all shareholders (friendly or hostile)Stock acquisition(on –market or off-market) Aust. ---- No stockholder vote required up to thresholdCan deal directly with stockholders, even if management is unfriendly---- Takeover offer to be made if ownership stake exceeds 20% with the exception of creeping acquisition allowance (3% each 6 months)Classifications ---- Horizontal– both firms are in the same industry. Vertical– firms are in different stages of the production process. --- Conglomerate– firms are unrelated. Synergy Most acquisitions fail to create value for the acquirer. The main reason why they do not lies in failures to integratetwo companies after a merger. Intellectual capital often walks out the door when acquisitions are not handled carefully. Traditionally, acquisitions deliver value when they allow for scale economies or market power, better products and services in the market, or learning from the new firms.The synergy from the acquisition is Synergy = VAB– (VA+ VB)Sources of Synergy : Revenue Enhancement ---- Cost Reduction ---Replacement of ineffective managersEconomy of scale or scope. ----- Tax Gains ; Net operating losses ; Unused debt capacityIncremental new investment required in working capital and fixed assets.Two Financial Side Effects of Acquisitions : Earnings Growth : If there are no synergies or other benefits to the merger, then the growth in EPS is just an artifact of a larger firm and is not true growth (i.e., an accounting illusion). Diversification : Shareholders who wish to diversify can accomplish this at much lower cost with one phone call to their broker than can management with a takeover.A Cost to Stockholders from Reduction in Risk : The Base Case : If two all-equity firms merge, there is no transfer of synergies to bondholders, but if… Both Firms Have Debt : The value of the levered shareholder’s call option falls. How Can Shareholders Reduce their Losses from the Coinsurance Effect?Coinsurance effect raises bond holders value and reduces shareholders value. Two ways share holders can reduce this 1.Retire debt before merger announcement date and re issue an equal amount of debt after merger because debt is realized at low pre merger price , this type of re financing can neutralize the effect on bond holders. 2. increase post-merger debt usage – The interest tax shield from new corporate debt raises firm value. Also raises probty Of fin. Distress meaning low or eliminating bond holder gain from this effect.