Corporate Strategy
Dr. Amin Wibowo, MBA
Takeovers, Restructuring, and Corporate Governance – Chapter 6
THEORIES OF MERGERS AND TENDER OFFERS
J. Fred Weston ● Mark L. Mitchell ● J. Harold Mulherin
MM UGM Yogyakarta, 18 December 2010
Group 3 AP-14 :
o Bayu Setiaji
o Nureni Susilowati
o Sri Muniati
The causes and effects of mergers
1. Why do mergers occurs ?
2. What are the possible effects of merger
activity on firm value ?
3. How does the merger process unfold ?
Examples of The Merger Process
1. The merger of Hewlett – Packard and Compaq
2. The acquisition of TRW by Northrop Grumman
HP / Compaq
Reasons for the Merger
Economies of scale in PCs
$ 2,5 billion in cost syergies
Price Reaction at Announcement HP Price declines 19%
Compaq declines 10%
Merger Process :
Private Activity
Public activity
CEOs have initial discussion (6/2001)
Extensive business due dilligence (6/2001)
Retain financial advisers (7/2001)
Board approve merger (9/3/2001)
Joint press release (9/3/2001)
Walter Hewlett opposes (11/5/2001)
Packard foundation opposes (12/8/2001)
Approval from FTC (3/7/2002)
Compaq holders approve (3/21/2002)
HP Holders formally approve (5/1/2002)
Northrop Grumman / TRW
Reasons for the
Merger
Economies of scale
Complementary product mix
Price Reaction at
Announcement
NG declines 6,7%
TRW increases 26,4%
Merger Process :
Private Activity
Public activity
NG makes $47 offer in letter (2/21/2002)
Offer 2 days after TRW CEO takes job at Honeywell
Letter says offer responsive to nonpublic information
Letter says NG plans to divest automotive
NG press release of offer (2/22/2002)
TRW rejects offer as inadequate (3/3/2002)
NG commences exchange offer (3/4/2002)
TRW rejects upped bid of $53 in stock (4/18/2002)
TRW, NG confidentiality pact (5/7/2002)
Merger agreement for $60 in stock (7/2/2002)
Merger Occurrence : Economies of Scale and
Transaction Costs
o Size and Returns To Scale
• Increase in firm size.
• Create economies of scale or synergies.
The larger the scale of operations is, the lower the
required investment in inventories is in relation to the
average quantity sold.
• Return to scale.
 source of return to scale is specialization
 improve capacity utilization that spreads fixed costs
over a larger number of units
distinction from economies of scope (produce
at lower cost because having experience)
o Transaction Costs and Mergers
Ronald Coase (1937) :
Firm size and mergers should be determined by the
relative transactions costs within and outside the firm.
Guidance for managers considering a merger decision
is weigh (comparative) transaction costs of separate
versus merged entitied before proceeding with a
merger transaction.
Some possible gains from a merger including costs
savings from economies of scale and better capacity
utilization, specialization is sometimes better achieved
by avoiding merge. (Bigger is not always better)
Theories of the Valuation Effects of Mergers and
Acquisitions
Theoretical Principle
Value Increasing
Transaction Cost Efficiency
Synergy
Disciplinary
Research Paper
Coase (1937)
Bradley, Desai, Kim (1983-1988)
Manne (1965)
Alchian and Demsetz (1972)
Value Reducing
Agency Costs of Free Cash Flow
Management Entrenchment
Jensen (1986)
Shleifer and Vishny (1989)
Value Neutral
Hubris
Roll (1986)
o Mergers as Value – Increasing Decisions
Coase :
- Merger increase value
- Firm responds to the appropriate balance between
the costs of using the market and the costs of
operating internally, such as technological change.
Bradley, Desai, and Kim :
- Merger create synergies  synergies economies
of scale, more effective management, improved
production techniques, and the combination of
complementary resources.
Mergers as Value – Increasing Decisions (Cont’d)
Manne, Alchian and Demsetz :
- Why a takeover transaction creates value is based
on disciplinary motives.
- Corporate takeovers as an integral component of
the market for corporate control.
- The takeover market facilitates competition among
different management teams.
- An acquisition to remove the existing officers that
are viewed as responsible for poor performance.
o Mergers as Value – Reducing Decisions
- Mergers are a source of value reduction
- In some models, disciplinary takeovers are a possible response
to a value-reducing merger.
Jensen :
Free cash flow is a source of value-reducing mergers,
A firm with high FCF is in excess of the investments required to
fund positive NPV projects.
Schleifer-Vishny : model of management entrenchment.
- Managers make investments that increase the manager’s
value to shareholders.
- Managers are hesitant to pay out cash to shareholders.
-Investment can be in the form of acquisition in which
managers overpay but lower the likelihood that
they will be replaced.
o Managerial Hubris and Mergers
Richard Roll :
- Merger bidding based on managerial hubris.
- Markets are strong form efficient (private information does not
produce above normal returns) but individual managers are
prone to excessive self confidence (excessive optimism) .
- The winner’s curse concept :
The winner is the bidder who has the highest estimate in
distribution, however the winner is cursed by the fact that the bid
was, in all likelihood, higher than the asset on firm’s actual value.
- The hubris theory : mergers can occur even if they have no
effects on value. The bid exceeds the target’s value, the
target sells and what is gained by the target shareholders
is a wealth transfer from the bidding firm’s owner.
Theoretical Predictions of The Patterns of
Gains in Takeovers
Effect mergers on target, bidder, and combined value.
• The value-increasing theories of mergers based on efficiency
and synergy predict that the combined value of the two
merging firms will increase and, therefore, the merger will
have a positive effect on firm value.
• The value-decreasing theories make alternative predictions.
The agency cost and entrenchment models predict that a
merger will have a negative effect on combined firm value.
• The hubris theory of takeovers suggest that merger
have no effect (zero) on combined firm’s value. Any
positive gain borne by target shareholders is merely a
wealth transfer from the buyer/bidder.
Theoretical Predictions of The Patterns of Gains in
Takeovers
Theory
Combined
Gains
Gains to
Target
Gains to
Bidder
Efficiency/Synergy Positive
Positive
Nonnegative
Agency Costs/
Entrenchment
Negative
Postive
More negative
Hubris
Zero
Positive
Negative
The Merger Process : The Acquisition of
Savannah Foods in 1997 (an example)
Date
Event
March 1996
Meeting of the board of directors of Savannah Foods
Board asks management for plan to improve stockholder value
Management aims to maximize value of existing sugar business
Also to consider diversifying, food related acquisitions
May 1996
Investment banks present acquisition candidates; no action
July 1996
Discussions with firms in beet sugar industry; no action
August 1996
Preliminary discussions with Flo-Sun, Inc; sugarcane grower
Feb 1997
Confidentiality agreement with Flo-Sun, Inc
May 12, 1997 Flo-sun,Inc.privately proposes a business combination
Nov 1996
Firm outside sugar industry expresses interest in a combination
Dec 1996
Board of directors rejects proposed combination
April 1997
Same diversification candidate renews proposal
May 25, 1997 Discussions with diversification candidate terminated
The Acquisition of Savannah Foods (cont’d)
Date
Event
July 15,1997
Savannah Foods and Flo-Sun,Inc, announce a merger agreement
Shareholders of Savannah Foods to own 41.5% of new company
Price of Savannah Foods falls 15.7% (from $18.6875 to $ 15.75)
July 25,1997
Savannah Foods sued by shareholders overproposed acquisition
July 16,1997
Imperial Holly Corp, a sugar refiner, contacts Lehman Brothers
July 25,1997
Lehman presents alternatives on an offer for Savannah Foods
Aug 25, 1997 Imperial offers $ 18.75 for Savannah Foods (70% cash,30%stock)
Sep 4, 1997
Flo-Sun, Inc. Revises offer
Savannah Foods to own 45% of new company plus $ 4 in cash
Sept 8,1997
Imperial and Flo-Sun both asked to submit best and final proposal
Sept 10,1997 Imperial ups offer to $20.25 per share (70% cash;30% stock)
Flo sun stands by its offer of September 4.
Sept 12,1997 Savannah Foods pays Flo-Sun a $ 5 million termination fee
Executes merger with Imperial Holly
Models of The Takeover Bidding Process
Concept
Decision
Variable
Research Paper
Winner’s Curse
Cash vs Stock
Hansen (1987)
Bidder Costs
Preemptive Bid
Termination Fee
Toehold
Hirshleifer and Png (1989)
Officer (2003)
Chowdry and Jegadeesh (1994)
Seller Decisions
Auction Design
Number of Bidder
Bulow,Huang, and Klemperer (1999)
French and McCormick (1984)
The Winner’s Curse
– Roll’s hubris hypothesis of mergers : the bidders in a
takeover attempt face a potential winner’s curse.
– Shading the bid too low would lessen the likelihood
completing a wealth-enhancing merger.
– Hansen : the root of problem is the lack of full knowledge
about the target’s value – knowledge is held by the target
firm itself.
– A bidder concerned about the value of the target can offer
stock rather than cash.
– Offer of stock is a contingent payment that internalized the
asymmetric information of the target firm.
Bidder Costs
– The cost of making the acquisition that is borne by bidder.
– Hirshleifer and Png (1989) : the presence of bidding costs
raises issues strategic interplay between the target firm and
potential bidders. Initial bidder make preemptive bid
precludes potential bidder to make a competing offer, the
target firm can often receive a higher price.
– Termination fee as part of the merger agreement, the
target firm was paid by a bidder when its deal was
terminated. (Officer, 2003)
– Chowdry and Jegadeesh (1994) : a toehold helps recoup
bidding costs. A potential bidder is whether to obtain an
initial stake or toehold prior to actively seeking control of
the target firm. The size of the toehold is a function
of the expected synergies from the merger.
Seller Decisions
– Any factor that affects bidders can have indirect and direct
effects on sellers, meaning the target firms in takeovers.
– Bulow, Huang, and Klemperer (1999) : interactive effects
of a bidder ‘s toehold on the price received by the target
firm. An initial toehold by one bidder might deter active
competition from other bidders and lessen gains to the
selling firm. A target firm can counteract this effect by the
shapping of auction design.
– French and McCormick (1984) : strategy in the face of
costly bidding and an endogenous number of bidders.
Central insight is in equilibrium, the selling firm bears the
costs borne by the bidder. The selling firm might want to
limit the number of bidders making detailed evaluations
of the value of the seller.
An Example of A Takeover Auction
Date
Event
Dec 16,1994
Board of Outlet communications, owner and operator of
television stations, authorizes exploration of strategic
alternatives
Feb 7, 1995
Engages Goldman Sachs as financial adviser
March 21, 1995
Issues press release announcing retention of Goldman Sachs
March 1995
Board determines that offers be solicited via an auction parties
March-May,95
Goldman Sachs contact / is contacted by 80 interestes parties
April-May 1995
Confidentially agreements with 45 parties
May 17, 1995
Preliminary proposals from 12 parties; range of $32 to $38
8 preliminary bidders invited to further due diligence
June 28,1995
5 bidders submit definitive proposals; range of $36.25 to $42.25
NBC’s bid was $38 / share in GE common stock
Bid from Renaissance Communications was $42.25 in cash
June 30, 1995
Board approves Renaissance merger agreement
July 28, 1995
Board receives written offer from NBC of $47.25 / share in cash
Aug 2, 1995
Terminates Renaissance agreement, approves NBC agreement
Conclusion
- Takeover bidding and the conceptual models of the
process are complex.
- The information costs of valuing the target and
determining the strategic fit of potential merger
partners make the decision of the buyer and seller in
a takeover bid important, yet difficult to specify.
- Economies of scale is a general motivation to merger.
- Gains to target — all empirical studies show gains are
positive.
- Gains to acquirer :
Positive — efficiency, synergy, or market power
Zero — overpaying, winner’s curse, hubris
Negative – agency problems or mistakes
THANK YOU