NLRB Representation Case Rule Changes Overview
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Chapter 22
Mergers and Acquisitions
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Chapter 22
Mergers and Acquisitions
Chapter Outline
22.1 Background and Historical Trends
22.2 Market Reaction to a Takeover
22.3 Reasons to Acquire
22.4 The Takeover Process
22.5 Takeover Defenses
22.6 Who Gets the Value Added from a Takeover?
Learning Objectives
Discuss the types of mergers and trends in merger activity.
Understand the stock price reactions to takeover
announcements.
Critically evaluate the different reasons to acquire.
Follow the major steps in the takeover process.
Learning Objectives (cont’d)
Discuss the main takeover defenses.
Identify factors that determine who gets the value-added
in a merger.
22.1 Background and Historical Trends
The market for corporate control
Acquirer (aka bidder)
Target
Two primary mechanisms
Acquisition
Merger
22.1 Background and Historical Trends
Merger Waves
Peaks of heavy takeover activity followed by troughs of few
transactions.
Merger activity is greater during economic expansions than
contractions
Also correlates with bull markets
Table 22.1
Twenty Largest Merger
Transactions, August 2000 – July 2010
Figure 22.1
Percentage of Public Companies
Taken Over Each Quarter, 1926-2010
22.1 Background and Historical Trends
Types of Mergers
Horizontal merger
Target and acquirer are in the same industry
Vertical merger
Target’s industry buys or sells to acquirer’s industry
Conglomerate merger
Target and bidder are in different industries
22.1 Background and Historical Trends
Types of Mergers
Stock swap
Cash merger or acquisition
Payments can be very complex
Usually some combination of forms of payment
22.2 Market Reaction to a Takeover
Most acquirers pay a substantial acquisition premium.
TABLE 22.2
Average Acquisition Premium and Stock Price Reactions to Mergers
22.2 Market Reaction to a Takeover
Three questions:
Why do acquirers pay a premium?
Why does the price of the target rise by less than the premium?
If the merger is a good idea, why does the acquirer’s price not
have a large increase?
22.3 Reasons to Acquire
Acquirer might be able to add economic value as a result
of the acquisition.
Synergies
22.3 Reasons to Acquire
Economies of Scale and Scope
Economies of scale
Savings from producing goods in high volume
Economies of scope
Savings from combining the marketing and distribution of related
products
22.3 Reasons to Acquire
Vertical Integration
Merger of two companies in the same industry that make
products required at different stages of the production cycle.
Principal benefit is coordination
22.3 Reasons to Acquire
Expertise
May be more efficient to purchase a company for its talent pool
that is already a functioning unit
Monopoly Gains
Antitrust laws
22.3 Reasons to Acquire
Efficiency Gains
Elimination of duplication
Improvement in poor management
Tax Savings from Operating Losses
Can’t write off a tax loss unless you have a profit elsewhere.
Example 22.1 Taxes for a Merged Corporation
Problem:
Consider two firms, Ying Corporation and Yang Corporation. Both
corporations will either make $50 million or lose $20 million every year
with equal probability. The only difference is that the firms’ profits are
perfectly negatively correlated. That is, any year Yang Corporation earns $50
million, Ying Corporation loses $20 million, and vice versa. Assume that the
corporate tax rate is 34%.
Example 22.1 Taxes for a Merged Corporation
Problem (cont’d):
What are the total expected after tax profits of both firms when they are
two separate firms? What are the expected after-tax profits if the two firms
are combined into one corporation called Ying-Yang Corporation, but are
run as two independent divisions? (Assume it is not possible to carry back
or carry forward any losses.)
Example 22.1 Taxes for a Merged Corporation
Solution:
Plan:
We need to calculate the after-tax profits of each firm in both
the profitable and unprofitable states by multiplying profits by
(1 – tax rate). We can then compute expected after-tax profits
as the weighted average of the after-tax profits in the profitable
and unprofitable states. If the firms are combined, their total
profits in any year would always be $50 million - $20 million =
$30 million, so the after-tax profit will always be $30 × (1- tax
rate).
Example 22.1 Taxes for a Merged Corporation
Execute:
Let’s start with Ying Corporation. In the profitable state, the firm must pay
corporate taxes, so after-tax profits are $50 × (1 - 0.34) = $33 million. No
taxes are owed when the firm reports losses, so the after-tax profits in the
unprofitable state are -$20 million.
Thus, the expected after-tax profits of Ying Corporation are 33(0.5) + (-
20)(0.5) = $6.5 million.
Example 22.1 Taxes for a Merged Corporation
Execute (cont’d):
Because Yang Corporation has identical expected profits, its expected
profits are also $6.5 million. Thus, the total expected profit of both
companies operated separately is $13 million.
The merged corporation, Ying-Yang Corporation, would have after-tax
profits of $30 × (1-0.34) = $19.8 million.
Example 22.1 Taxes for a Merged Corporation
Evaluate:
Ying-Yang Corporation has significantly higher after-tax profits than the total
stand-alone after-tax profits of Ying Corporation and Yang Corporation. This
is because the losses on one division reduce the taxes on the other
division’s profits.
Example 22.1a Taxes for a Merged
Corporation
Problem:
Consider two firms, Tally Corporation and Ho Corporation. Both
corporations will either make $100 million or lose $50 million every year
with equal probability. The only difference is that the firms’ profits are
perfectly negatively correlated. That is, any year Tally Corporation earns
$100 million, Ho Corporation loses $50 million, and vice versa. Assume that
the corporate tax rate is 34%.
Example 22.1a Taxes for a Merged
Corporation
Problem (cont’d):
What are the total expected after tax profits of both firms when they are
two separate firms? What are the expected after-tax profits if the two firms
are combined into one corporation called Tally-Ho Corporation, but are run
as two independent divisions? (Assume it is not possible to carry back or
carry forward any losses.)
Example 22.1a Taxes for a Merged
Corporation
Solution:
Plan:
We need to calculate the after-tax profits of each firm in both
the profitable and unprofitable states by multiplying profits by
(1 – tax rate). We can then compute expected after-tax profits
as the weighted average of the after-tax profits in the profitable
and unprofitable states. If the firms are combined, their total
profits in any year would always be $100 million - $50 million =
$50 million, so the after-tax profit will always be $50 × (1- tax
rate).
Example 22.1a Taxes for a Merged
Corporation
Execute:
Let’s start with Tally Corporation. In the profitable state, the firm must pay
corporate taxes, so after-tax profits are $100 × (1 - 0.34) = $66 million. No
taxes are owed when the firm reports losses, so the after-tax profits in the
unprofitable state are -$50 million.
Thus, the expected after-tax profits of Tally Corporation are 66(0.5) + (-
50)(0.5) = $8.0 million.
Example 22.1a Taxes for a Merged
Corporation
Execute (cont’d):
Because Ho Corporation has identical expected profits, its expected profits
are also $8.0 million. Thus, the total expected profit of both companies
operated separately is $16 million.
The merged corporation, Tally-Ho Corporation, would have after-tax profits
of $50 × (1-0.34) = $33 million.
Example 22.1a Taxes for a Merged
Corporation
Evaluate:
Tally-Ho Corporation has significantly higher after-tax profits than the total
stand-alone after-tax profits of Tally Corporation and Ho Corporation. This
is because the losses on one division reduce the taxes on the other
division’s profits.
22.3 Reasons to Acquire
Diversification
Risk reduction
Debt capacity and borrowing costs
Liquidity
22.3 Reasons to Acquire
Earnings growth
It is possible that two companies combined can have higher
earnings per share than the premerger earnings per share of
either company, even if the merger creates no economic value.
Example 22.2 Mergers and Earnings Per
Share
Problem:
Consider two corporations that both have earnings of $5 per
share. The first firm, OldWorld Enterprises, is a mature
company with few growth opportunities. It has 1 million shares
that are currently outstanding, priced at $60 per share. The
second company, NewWorld Corporation, is a young company
with much more lucrative growth opportunities. Consequently,
it has a higher value: Although it has the same number of shares
outstanding, its stock price is $100 per share.
Example 22.2 Mergers and Earnings Per
Share
Problem (cont’d):
Assume NewWorld acquires OldWorld using its own stock, and the
takeover adds no value. In a perfect market, what is the value of NewWorld
after the acquisition? At current market prices, how many shares must
NewWorld offer to OldWorld’s shareholders in exchange for their shares?
Finally, what are NewWorld’s earnings per share after the acquisition?
Example 22.2 Mergers and Earnings Per
Share
Solution:
Plan:
Because the takeover adds no value, the post-takeover value of
NewWorld is just the sum of the values of the two separate
companies: 100 × 1 million + 60 × 1 million = $160 million. To
acquire OldWorld, NewWorld must pay $60 million. We need
to first calculate how many shares NewWorld must issue to
pay OldWorld shareholders $60 million. The ratio of
NewWorld shares issued to OldWorld Shares will give us the
exchange ratio.
Example 22.2 Mergers and Earnings Per
Share
Plan (cont’d):
Once we know how many new shares will be issued, we can divide the total
earnings of the combined company by the new total number of shares
outstanding to get the earnings per share.
Example 22.2 Mergers and Earnings Per
Share
Execute:
At its pre-takeover stock price of $100 per share, the deal
requires issuing 600,000 shares ($60 million / $100 = 600,000).
As a group, OldWorld’s shareholders will then exchange 1
million shares in OldWorld for 600,000 shares in NewWorld.
The exchange ratio is the ratio of issued shares to exchanged
shares: 600,000/1 million = 0.6. Therefore, each OldWorld
shareholder will get 0.6 share in NewWorld for each 1 share in
OldWorld
Example 22.2 Mergers and Earnings Per
Share
Execute (cont’d):
Notice that the price per share of NewWorld stock is the
same after the takeover: The new value of NewWorld is $160
million and there are 1.6 million shares outstanding, giving it a
stock price of $100 per share.
However, NewWorld’s earnings per share have changed. Prior
to the takeover, both companies earned $5/share ×1 million
shares = $5 million. The combined corporation thus earns $10
million.
Example 22.2 Mergers and Earnings Per
Share
Execute (cont’d):
There are 1.6 million shares outstanding after the takeover, so
NewWorld’s post-takeover earnings per share are
By taking over OldWorld, NewWorld has raised its earnings
per share by $1.25.
Example 22.2 Mergers and Earnings Per
Share
Evaluate:
Because no value was created, we can think of the combined company as
simply a portfolio of NewWorld and OldWorld. Although the portfolio has
higher total earnings per share, it also has lower growth because we have
combined the low-growth OldWorld with the high-growth NewWorld. The
higher current earnings per share has come at a price—lower earnings per
share growth.
Example 22.2a Mergers and Earnings Per
Share
Problem:
Consider two corporations that both have earnings of $8 per
share. The first firm, Beenaround, is a mature company with few
growth opportunities. It has 2 million shares that are currently
outstanding, priced at $50 per share. The second company,
Movenin Corporation, is a young company with much more
lucrative growth opportunities. Consequently, it has a higher
value: Although it has the same number of shares outstanding,
its stock price is $80 per share.
Example 22.2a Mergers and Earnings Per
Share
Problem (cont’d):
Assume Movenin acquires Beenaround using its own stock, and the
takeover adds no value. In a perfect market, what is the value of Movenin
after the acquisition? At current market prices, how many shares must
Movenin offer to Beenaround’s shareholders in exchange for their shares?
Finally, what are Movenin’s earnings per share after the acquisition?
Example 22.2a Mergers and Earnings Per
Share
Solution:
Plan:
Because the takeover adds no value, the post-takeover value of
Movenin is just the sum of the values of the two separate
companies: 50 × 2 million + 80 × 2 million = $260 million. To
acquire Beenaround, Movenin must pay $100 million. We need
to first calculate how many shares Movenin must issue to pay
Beenaround shareholders $100 million. The ratio of Movenin
shares issued to Beenaround Shares will give us the exchange
ratio.
Example 22.2a Mergers and Earnings Per
Share
Plan (cont’d):
Once we know how many new shares will be issued, we can divide the total
earnings of the combined company by the new total number of shares
outstanding to get the earnings per share.
Example 22.2a Mergers and Earnings Per
Share
Execute:
At its pre-takeover stock price of $80 per share, the deal
requires issuing 1,250,000 shares ($100 million / $80 =
1,250,000). As a group, Beenaround’s shareholders will then
exchange 2 million shares in Beenaround for 1,250,000 shares
in Movenin. The exchange ratio is the ratio of issued shares to
exchanged shares: 1,250,000/2 million = 0.625. Therefore, each
Beenaround shareholder will get 0.625 share in Movenin for
each 1 share in Beenaround
Example 22.2a Mergers and Earnings Per
Share
Execute (cont’d):
Notice that the price per share of Movenin stock is the same
after the takeover: The new value of Movenin is $260 million
and there are 3.25 million shares outstanding, giving it a stock
price of $80 per share.
However, Movenin’s earnings per share have changed. Prior to
the takeover, both companies earned $8/share ×2 million
shares = $16 million. The combined corporation thus earns
$32 million.
Example 22.2a Mergers and Earnings Per
Share
Execute (cont’d):
There are 3.25 million shares outstanding after the takeover, so
Movenin’s post-takeover earnings per share are
By taking over Beenaround, Movenin has raised its earnings per
share by $1.85.
Example 22.2a Mergers and Earnings Per
Share
Evaluate:
Because no value was created, we can think of the combined company as
simply a portfolio of Movenin and Beenaround. Although the portfolio has
higher total earnings per share, it also has lower growth because we have
combined the low-growth Beenaround with the high-growth Movenin. The
higher current earnings per share has come at a price—lower earnings per
share growth.
Example 22.3 Mergers and the Price-Earnings
Ratio
Problem:
Calculate NewWorld’s price-earnings ratio, before and after the takeover
described in Example 22.2.
Example 22.3 Mergers and the Price-Earnings
Ratio
Solution:
Plan:
The price-earnings ratio is price per share / earnings per share. NewWorld’s
price per share is $100 both before and after the takeover, and its earnings
per share is $5 before and $6.25 after the takeover.
Example 22.3 Mergers and the Price-Earnings
Ratio
Execute:
Before the takeover, NewWorld’s price-earnings ratio is:
After the takeover, NewWorld’s price-earnings ratio is:
Example 22.3 Mergers and the Price-Earnings
Ratio
Evaluate:
The price-earnings ratio has dropped to reflect the fact that after taking
over OldWorld, more of the value of NewWorld comes from earnings from
current projects than from its future growth potential.
Example 22.3a Mergers and the Price-
Earnings Ratio
Problem:
Calculate Movenin’s price-earnings ratio, before and after the takeover
described in Example 22.2a.
Example 22.3a Mergers and the Price-
Earnings Ratio
Solution:
Plan:
The price-earnings ratio is price per share / earnings per share. Movenin’s
price per share is $80 both before and after the takeover, and its earnings
per share is $8 before and $9.85 after the takeover.
Example 22.3a Mergers and the Price-
Earnings Ratio
Execute:
Before the takeover, Movenin’s price-earnings ratio is:
After the takeover, Movenin’s price-earnings ratio is:
Example 22.3a Mergers and the Price-
Earnings Ratio
Evaluate:
The price-earnings ratio has dropped to reflect the fact that after taking
over Beenaround, more of the value of Movenin comes from earnings from
current projects than from its future growth potential.
22.3 Reasons to Acquire
Managerial motives to merge
Conflicts of interest
Overconfidence
22.4 The Takeover Process
Valuation
Compare the target to similar companies
Rough estimate
Does not incorporate synergies
Discounted cash flows
Harder to implement, but does include synergies
22.4 The Takeover Process
The Offer
Public announcement
Cash transaction
Stock swap
Exchange ratio
Positive NPV transaction if share price of merged firm exceeds premerger
acquirer price
22.4 The Takeover Process
Stock swap is positive NPV if:
Where:
A = premerger value of acquirer
T = premerger value of target
S = value of synergies
N
A
= shares outstanding of acquirer premerger
x = number of shares issued in the merger
Eq. 22.1
22.4 The Takeover Process
Re-writing eq. 22.1 to solve for the maximum value of x
that will still give a positive NPV:
Eq. 22.2
22.4 The Takeover Process
We can express this as an exchange ratio by dividing both
sides by the premerger number of target shares (
N
T
):
Eq. 22.3
22.4 The Takeover Process
Rewrite Eq. 22.3 in terms of
premerger
target and acquirer
share prices
P
T
=T/N
T
and
P
A
=A/N
A
:
Eq. 22.4
Example 22.4 Maximum Exchange Ratio in a
Stock Takeover
Problem:
At the time Sprint announced plans to acquire Nextel in December 2004,
Sprint stock was trading for $25 per share and Nextel stock was trading for
$30 per share. If the projected synergies were $12 billion, and Nextel had
1.033 billion shares outstanding, what is the maximum exchange ratio Sprint
could offer in a stock swap and still generate a positive NPV? What is the
maximum cash offer Sprint could make?
Example 22.4 Maximum Exchange Ratio in a
Stock Takeover
Solution:
Plan:
We can use Eq. 22.4 to compute the maximum shares Sprint could offer and
still have a positive NPV. To compute the maximum cash offer, we can
calculate the synergies per share and add that to Nextel’s current share
price.
Example 22.4 Maximum Exchange Ratio
in a Stock Takeover
Execute:
Using Eq. 22.4,
That is, Sprint could offer up to 1.665 shares of Sprint stock for each share
of Nextel stock and generate a positive NPV.
For a cash offer, given synergies of $12 billion/1.033 billion shares = $11.62
per share, Sprint could offer up to $30 + 11.62 = $41.62.
Example 22.4 Maximum Exchange Ratio
in a Stock Takeover
Evaluate:
Both the cash amount and the exchange offer ($25 × 1.665 = $41.62) have
the same value. That value is the most that Nextel is worth to Sprint - if
Sprint pays $41.62 for Nextel, it is paying full price plus paying Nextel
shareholders for all the synergy gains created - leaving none for Sprint
shareholders. Thus, at $41.62, buying Nextel is exactly a zero-NPV project.
22.4 The Takeover Process
Merger Arbitrage
Uncertainty about the takeover’s success
Hence, market price does not rise by the amount of the premium
upon announcement.
Risk arbitrageurs
Merger-arbitrage spread
Difference between target’s stock price and implied offer price.
Not really arbitrage
Figure 22.2
Merger-Arbitrage Spread for
the Merger of HP and Compaq
22.4 The Takeover Process
Tax and Accounting Issues
Form of payment affects taxes of target shareholders and
combined firm.
Cash received triggers immediate tax liability.
Stock swap defers taxes until shares are sold.
22.4 The Takeover Process
Tax and Accounting Issues
If acquirer purchases target assets directly, basis is stepped up.
Higher depreciable basis reduces future taxes
Goodwill can be amortized.
22.4 The Takeover Process
Board and Shareholder Approval
Friendly takeover
Hostile takeover
Corporate raider
22.4 The Takeover Process
Board and Shareholder Approval
Board may not approve even if a premium is offered
Might think offer price is too low
In a stock swap, might think acquirer is overvalued
Might be self interest (agency problem)
Many times entire management team is changed
22.4 The Takeover Process
Board and Shareholder Approval
In theory, target board’s duty is to act in the best interest of
target shareholders.
Revlon duties – must seek the highest value
Unocal – when board takes defensive actions those actions are subject
to extra scrutiny
Defenses must not be coercive or designed to preclude a deal
22.5 Takeover Defenses
Proxy fight
Acquirer attempts to convince target shareholders to use
proxy votes to support acquirers’ candidates for election to the
target board.
Several strategies to stop this process:
Can force a bidder to raise the bid.
Can entrench management more securely.
22.5 Takeover Defenses
Poison Pills
Rights offering that gives existing target shareholders the right
to buy shares in the target at a deeply discounted price under
certain conditions.
Makes it more difficult to replace bad managers
Firm’s stock price drops when poison pill is adopted
Firms with poison pills have below average financial performance
22.5 Takeover Defenses
Staggered Boards
Board of directors’ terms are staggered so that only one-third
of the directors are up for election each year.
White Knights
Target looks for a friendlier company to acquire it.
White squire
22.5 Takeover Defenses
Golden Parachutes
Lucrative severance package guaranteed to senior managers in
the event that the firm is taken over and the managers are let
go.
Empirical evidence suggests that it is value-increasing because
management is more likely to be receptive to a takeover.
22.5 Takeover Defenses
Recapitalization
Company changes capital structure to make itself less attractive.
For example, pay out large dividend
Other Defensive Strategies
Supermajority
Restricted voting rights for large shareholders
“Fair” price
22.5 Takeover Defenses
Regulatory Approval
Sherman Act
Clayton Act
Hart-Scott-Rodino Act
22.6 Who Gets the Value Added from a
Takeover?
The Free Rider Problem
Assume HighLife Corporation has 1 million shareholders, each
holding 1 share.
The management is not doing a good job, so the shares trade at
a deep discount.
They currently trade at $45 per share
With good management they could be worth $75 each
22.6 Who Gets the Value Added from a
Takeover?
The Free Rider Problem
A simple majority is required to make all decisions, so control
can be bought with 50% of outstanding shares.
T. Boone Icon wants to fix the situation by making a tender
offer at $60 per share.
If 50% of shareholders tender, T. Boone makes a large profit ($15 per
share when performance improves).
22.6 Who Gets the Value Added from a
Takeover?
The Free Rider Problem
The offer price exceeds the current price, so tendering
shareholders make a profit ($60 - $45 = $15 per share).
However, if the offer succeeds, remaining shareholders make a
higher profit ($75 - $45 = $30 per share) by allowing the other
shareholders to tender.
22.6 Who Gets the Value Added from a
Takeover?
The Free Rider Problem
All shareholders know this, so the offer will not be successful.
The only way enough shareholders will tender is for T. Boone
to offer at least $75 per share.
The raider gives up his profit.
Existing shareholders do not have to invest time and effort, hence the
term “free rider.”
22.6 Who Gets the Value Added from a
Takeover?
Toeholds
An initial ownership stake in a firm that a corporate raider can
use to initiate a takeover attempt.
T. Boone can acquire up to about 10% of the firm in secret.
He can then buy another 40% for $75 per share and realize a profit
from his initial 10%.
Corporate raiders perform an important service because
management knows they exist.
22.6 Who Gets the Value Added from a
Takeover?
The Leveraged Buyout
Another lower-cost mechanism for corporate raiders
T. Boone announces a tender offer for half the outstanding
shares at $50 per share.
Instead of using his own cash, he borrows money through a shell
corporation with the shares as collateral.
If the tender offer succeeds, T. Boone can merge the target with the
shell corporation and debt is owed by the target.
Shareholders will tender because the outstanding debt makes the
share price $50 after the takeover.
Example 22.5 Leveraged Buyout
Problem:
FAT Corporation stock is currently trading at $40 per share. There are 20
million shares outstanding, and the company has no debt. You are a partner
in a firm that specializes in leveraged buyouts. Your analysis indicates that the
management of this corporation could be improved considerably. If the
managers were replaced with more capable ones, you estimate that the
value of the company would increase by 50%.
Example 22.5 Leveraged Buyout
Problem (cont’d):
You decide to initiate a leveraged buyout and issue a tender offer for at
least a controlling interest—50% of the outstanding shares. What is the
maximum amount of value you can extract and still complete the deal?
Example 22.5 Leveraged Buyout
Solution:
Plan:
Currently, the value of the company is $40 × 20 million = $800
million and you estimate you can add an additional 50%, or
$400 million. If you borrow $400 million and the tender offer
succeeds, you will take control of the company and install new
management. The total value of the company will increase by
50% to $1.2 billion. You will also attach the debt to the
company, so the company will now have $400 million in debt.
Example 22.5 Leveraged Buyout
Plan (cont’d):
You can then compute the value of the post-takeover equity and your gain.
You can repeat this computation assuming you borrow more than $400
million and confirming that your gain does not change.
Example 22.5 Leveraged Buyout
Execute:
The value of the equity once the deal is done is the total value minus the
debt outstanding:
Total Equity = $1200 million - $400 million = $800 million
The value of the equity is the same as the premerger value. You own half the
shares, which are worth $400 million, and paid nothing for them, so you
have captured the value you anticipated adding to FAT.
Example 22.5 Leveraged Buyout
Execute (cont’d):
What if you borrowed more than $400 million? Assume you
were able to borrow $450 million. The value of equity after the
merger would be:
Total Equity = $1200 million - $450 million = $750 million
This is lower than the premerger value. Recall, however, that in
the United States, existing shareholders must be offered at
least the premerger price for their shares.
Example 22.5 Leveraged Buyout
Execute (cont’d):
Because existing shareholders anticipate that the share price
will be lower once the deal is complete, all shareholders will
tender their shares. This implies that you will have to pay $800
million for these shares, and so to complete the deal, you will
have to pay $800 million - $450 million = $350 million out of
your own pocket. In the end, you will own all the equity, which
is worth $750 million. You paid $350 million for it, so your
profit is again $400 million.
Example 22.5 Leveraged Buyout
Evaluate:
In each case, the most you can gain is the $400 million in value you add by
taking over FAT. Thus, you cannot extract more value than the value you add
to the company by taking it over.
22.6 Who Gets the Value Added from a
Takeover?
The Freezout Merger
Used by companies acquiring other companies
Leveraged buyout is used by groups of investors
Acquiring company makes a tender offer at a slight premium
If offer succeeds, acquirer gains control and merges into a new
corporation.
Non-tendering shareholders get the right to receive the tender offer
price.
22.6 Who Gets the Value Added from a
Takeover?
Competition
Competition in the takeover market means that most of the
benefit to the merger goes to target shareholders.
If the premium is not high enough, another company will submit a
higher bid.
Chapter Quiz
1.
What are merger waves?
2.
What is the difference between a horizontal and a vertical
merger?
3.
On average, what happens to the target share price on the
announcement of a takeover?
4.
On average, what happens to the acquirer share price on the
announcement of a takeover?
Chapter Quiz (cont’d)
5.
Explain why risk diversification benefits and earnings growth
are not good justifications for a takeover intended to increase
shareholder wealth.
6.
What are the steps in the takeover process?
7.
What do risk arbitrageurs do?
8.
What defensive strategies are available to help target
companies resist an unwanted takeover?
9.
How can a hostile acquirer get around a poison pill?
Chapter Quiz (cont’d)
10. What mechanisms allow corporate raiders to get around the
free rider problem in takeovers?
11. Based on the empirical evidence, who gets the value added
from a takeover? What is the most likely explanation of this
fact?
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Chapter 22 Mergers and Acquisitions
Chapter 22 Mergers and Acquisitions
Chapter Outline 22.1 Background and Historical Trends 22.2 Market Reaction to a Takeover 22.3 Reasons to Acquire 22.4 The Takeover Process 22.5 Takeover Defenses 22.6 Who Gets the Value Added from a Takeover?
Learning Objectives Discuss the types of mergers and trends in merger activity. Understand the stock price reactions to takeover announcements. Critically evaluate the different reasons to acquire. Follow the major steps in the takeover process.
Learning Objectives (contd) Discuss the main takeover defenses. Identify factors that determine who gets the value-added in a merger.
22.1 Background and Historical Trends The market for corporate control Acquirer (aka bidder) Target Two primary mechanisms Acquisition Merger
22.1 Background and Historical Trends Merger Waves Peaks of heavy takeover activity followed by troughs of few transactions. Merger activity is greater during economic expansions than contractions Also correlates with bull markets
Table 22.1 Twenty Largest Merger Transactions, August 2000 July 2010
Figure 22.1 Percentage of Public Companies Taken Over Each Quarter, 1926-2010
22.1 Background and Historical Trends Types of Mergers Horizontal merger Target and acquirer are in the same industry Vertical merger Target s industry buys or sells to acquirer s industry Conglomerate merger Target and bidder are in different industries
22.1 Background and Historical Trends Types of Mergers Stock swap Cash merger or acquisition Payments can be very complex Usually some combination of forms of payment
22.2 Market Reaction to a Takeover Most acquirers pay a substantial acquisition premium. TABLE 22.2 Average Acquisition Premium and Stock Price Reactions to Mergers
22.2 Market Reaction to a Takeover Three questions: Why do acquirers pay a premium? Why does the price of the target rise by less than the premium? If the merger is a good idea, why does the acquirer s price not have a large increase?
22.3 Reasons to Acquire Acquirer might be able to add economic value as a result of the acquisition. Synergies
22.3 Reasons to Acquire Economies of Scale and Scope Economies of scale Savings from producing goods in high volume Economies of scope Savings from combining the marketing and distribution of related products
22.3 Reasons to Acquire Vertical Integration Merger of two companies in the same industry that make products required at different stages of the production cycle. Principal benefit is coordination
22.3 Reasons to Acquire Expertise May be more efficient to purchase a company for its talent pool that is already a functioning unit Monopoly Gains Antitrust laws
22.3 Reasons to Acquire Efficiency Gains Elimination of duplication Improvement in poor management Tax Savings from Operating Losses Can t write off a tax loss unless you have a profit elsewhere.
Example 22.1 Taxes for a Merged Corporation Problem: Consider two firms, Ying Corporation and Yang Corporation. Both corporations will either make $50 million or lose $20 million every year with equal probability. The only difference is that the firms profits are perfectly negatively correlated. That is, any year Yang Corporation earns $50 million, Ying Corporation loses $20 million, and vice versa. Assume that the corporate tax rate is 34%.
Example 22.1 Taxes for a Merged Corporation Problem (cont d): What are the total expected after tax profits of both firms when they are two separate firms? What are the expected after-tax profits if the two firms are combined into one corporation called Ying-Yang Corporation, but are run as two independent divisions? (Assume it is not possible to carry back or carry forward any losses.)
Example 22.1 Taxes for a Merged Corporation Solution: Plan: We need to calculate the after-tax profits of each firm in both the profitable and unprofitable states by multiplying profits by (1 tax rate). We can then compute expected after-tax profits as the weighted average of the after-tax profits in the profitable and unprofitable states. If the firms are combined, their total profits in any year would always be $50 million - $20 million = $30 million, so the after-tax profit will always be $30 (1- tax rate).
Example 22.1 Taxes for a Merged Corporation Execute: Let s start with Ying Corporation. In the profitable state, the firm must pay corporate taxes, so after-tax profits are $50 (1 - 0.34) = $33 million. No taxes are owed when the firm reports losses, so the after-tax profits in the unprofitable state are -$20 million. Thus, the expected after-tax profits of Ying Corporation are 33(0.5) + (- 20)(0.5) = $6.5 million.
Example 22.1 Taxes for a Merged Corporation Execute (cont d): Because Yang Corporation has identical expected profits, its expected profits are also $6.5 million. Thus, the total expected profit of both companies operated separately is $13 million. The merged corporation, Ying-Yang Corporation, would have after-tax profits of $30 (1-0.34) = $19.8 million.
Example 22.1 Taxes for a Merged Corporation Evaluate: Ying-Yang Corporation has significantly higher after-tax profits than the total stand-alone after-tax profits of Ying Corporation and Yang Corporation. This is because the losses on one division reduce the taxes on the other division s profits.
Example 22.1a Taxes for a Merged Corporation Problem: Consider two firms, Tally Corporation and Ho Corporation. Both corporations will either make $100 million or lose $50 million every year with equal probability. The only difference is that the firms profits are perfectly negatively correlated. That is, any year Tally Corporation earns $100 million, Ho Corporation loses $50 million, and vice versa. Assume that the corporate tax rate is 34%.
Example 22.1a Taxes for a Merged Corporation Problem (cont d): What are the total expected after tax profits of both firms when they are two separate firms? What are the expected after-tax profits if the two firms are combined into one corporation called Tally-Ho Corporation, but are run as two independent divisions? (Assume it is not possible to carry back or carry forward any losses.)
Example 22.1a Taxes for a Merged Corporation Solution: Plan: We need to calculate the after-tax profits of each firm in both the profitable and unprofitable states by multiplying profits by (1 tax rate). We can then compute expected after-tax profits as the weighted average of the after-tax profits in the profitable and unprofitable states. If the firms are combined, their total profits in any year would always be $100 million - $50 million = $50 million, so the after-tax profit will always be $50 (1- tax rate).
Example 22.1a Taxes for a Merged Corporation Execute: Let s start with Tally Corporation. In the profitable state, the firm must pay corporate taxes, so after-tax profits are $100 (1 - 0.34) = $66 million. No taxes are owed when the firm reports losses, so the after-tax profits in the unprofitable state are -$50 million. Thus, the expected after-tax profits of Tally Corporation are 66(0.5) + (- 50)(0.5) = $8.0 million.
Example 22.1a Taxes for a Merged Corporation Execute (cont d): Because Ho Corporation has identical expected profits, its expected profits are also $8.0 million. Thus, the total expected profit of both companies operated separately is $16 million. The merged corporation, Tally-Ho Corporation, would have after-tax profits of $50 (1-0.34) = $33 million.
Example 22.1a Taxes for a Merged Corporation Evaluate: Tally-Ho Corporation has significantly higher after-tax profits than the total stand-alone after-tax profits of Tally Corporation and Ho Corporation. This is because the losses on one division reduce the taxes on the other division s profits.
22.3 Reasons to Acquire Diversification Risk reduction Debt capacity and borrowing costs Liquidity
22.3 Reasons to Acquire Earnings growth It is possible that two companies combined can have higher earnings per share than the premerger earnings per share of either company, even if the merger creates no economic value.
Example 22.2 Mergers and Earnings Per Share Problem: Consider two corporations that both have earnings of $5 per share. The first firm, OldWorld Enterprises, is a mature company with few growth opportunities. It has 1 million shares that are currently outstanding, priced at $60 per share. The second company, NewWorld Corporation, is a young company with much more lucrative growth opportunities. Consequently, it has a higher value: Although it has the same number of shares outstanding, its stock price is $100 per share.
Example 22.2 Mergers and Earnings Per Share Problem (cont d): Assume NewWorld acquires OldWorld using its own stock, and the takeover adds no value. In a perfect market, what is the value of NewWorld after the acquisition? At current market prices, how many shares must NewWorld offer to OldWorld s shareholders in exchange for their shares? Finally, what are NewWorld s earnings per share after the acquisition?
Example 22.2 Mergers and Earnings Per Share Solution: Plan: Because the takeover adds no value, the post-takeover value of NewWorld is just the sum of the values of the two separate companies: 100 1 million + 60 1 million = $160 million. To acquire OldWorld, NewWorld must pay $60 million. We need to first calculate how many shares NewWorld must issue to pay OldWorld shareholders $60 million. The ratio of NewWorld shares issued to OldWorld Shares will give us the exchange ratio.
Example 22.2 Mergers and Earnings Per Share Plan (cont d): Once we know how many new shares will be issued, we can divide the total earnings of the combined company by the new total number of shares outstanding to get the earnings per share.
Example 22.2 Mergers and Earnings Per Share Execute: At its pre-takeover stock price of $100 per share, the deal requires issuing 600,000 shares ($60 million / $100 = 600,000). As a group, OldWorld s shareholders will then exchange 1 million shares in OldWorld for 600,000 shares in NewWorld. The exchange ratio is the ratio of issued shares to exchanged shares: 600,000/1 million = 0.6. Therefore, each OldWorld shareholder will get 0.6 share in NewWorld for each 1 share in OldWorld
Example 22.2 Mergers and Earnings Per Share Execute (cont d): Notice that the price per share of NewWorld stock is the same after the takeover: The new value of NewWorld is $160 million and there are 1.6 million shares outstanding, giving it a stock price of $100 per share. However, NewWorld s earnings per share have changed. Prior to the takeover, both companies earned $5/share 1 million shares = $5 million. The combined corporation thus earns $10 million.
Example 22.2 Mergers and Earnings Per Share Execute (cont d): There are 1.6 million shares outstanding after the takeover, so NewWorld s post-takeover earnings per share are $10million 1.6millionshares = $6.25/share EPS = By taking over OldWorld, NewWorld has raised its earnings per share by $1.25.
Example 22.2 Mergers and Earnings Per Share Evaluate: Because no value was created, we can think of the combined company as simply a portfolio of NewWorld and OldWorld. Although the portfolio has higher total earnings per share, it also has lower growth because we have combined the low-growth OldWorld with the high-growth NewWorld. The higher current earnings per share has come at a price lower earnings per share growth.
Example 22.2a Mergers and Earnings Per Share Problem: Consider two corporations that both have earnings of $8 per share. The first firm, Beenaround, is a mature company with few growth opportunities. It has 2 million shares that are currently outstanding, priced at $50 per share. The second company, Movenin Corporation, is a young company with much more lucrative growth opportunities. Consequently, it has a higher value: Although it has the same number of shares outstanding, its stock price is $80 per share.
Example 22.2a Mergers and Earnings Per Share Problem (cont d): Assume Movenin acquires Beenaround using its own stock, and the takeover adds no value. In a perfect market, what is the value of Movenin after the acquisition? At current market prices, how many shares must Movenin offer to Beenaround s shareholders in exchange for their shares? Finally, what are Movenin s earnings per share after the acquisition?
Example 22.2a Mergers and Earnings Per Share Solution: Plan: Because the takeover adds no value, the post-takeover value of Movenin is just the sum of the values of the two separate companies: 50 2 million + 80 2 million = $260 million. To acquire Beenaround, Movenin must pay $100 million. We need to first calculate how many shares Movenin must issue to pay Beenaround shareholders $100 million. The ratio of Movenin shares issued to Beenaround Shares will give us the exchange ratio.
Example 22.2a Mergers and Earnings Per Share Plan (cont d): Once we know how many new shares will be issued, we can divide the total earnings of the combined company by the new total number of shares outstanding to get the earnings per share.
Example 22.2a Mergers and Earnings Per Share Execute: At its pre-takeover stock price of $80 per share, the deal requires issuing 1,250,000 shares ($100 million / $80 = 1,250,000). As a group, Beenaround s shareholders will then exchange 2 million shares in Beenaround for 1,250,000 shares in Movenin. The exchange ratio is the ratio of issued shares to exchanged shares: 1,250,000/2 million = 0.625. Therefore, each Beenaround shareholder will get 0.625 share in Movenin for each 1 share in Beenaround
Example 22.2a Mergers and Earnings Per Share Execute (cont d): Notice that the price per share of Movenin stock is the same after the takeover: The new value of Movenin is $260 million and there are 3.25 million shares outstanding, giving it a stock price of $80 per share. However, Movenin s earnings per share have changed. Prior to the takeover, both companies earned $8/share 2 million shares = $16 million. The combined corporation thus earns $32 million.
Example 22.2a Mergers and Earnings Per Share Execute (cont d): There are 3.25 million shares outstanding after the takeover, so Movenin s post-takeover earnings per share are $32million 3.25millionshares = $9.85/share EPS = By taking over Beenaround, Movenin has raised its earnings per share by $1.85.
Example 22.2a Mergers and Earnings Per Share Evaluate: Because no value was created, we can think of the combined company as simply a portfolio of Movenin and Beenaround. Although the portfolio has higher total earnings per share, it also has lower growth because we have combined the low-growth Beenaround with the high-growth Movenin. The higher current earnings per share has come at a price lower earnings per share growth.
Example 22.3 Mergers and the Price-Earnings Ratio Problem: Calculate NewWorld s price-earnings ratio, before and after the takeover described in Example 22.2.
Example 22.3 Mergers and the Price-Earnings Ratio Solution: Plan: The price-earnings ratio is price per share / earnings per share. NewWorld s price per share is $100 both before and after the takeover, and its earnings per share is $5 before and $6.25 after the takeover.
