MERGERS AND ACQUISITIONS
Rationale for Mergers
Synergy
• The primary motivation for most mergers is to
increase the value of the combined enterprise. For
eg. if companies A and B merge to form Company C,
and if C’s value exceeds that of A and B taken
separately, then synergy is said to exist.
• Illustration: A and B have similar assets and
business risk with overall cost of capital of 25% . All
equity financed. Suppose after-tax cash flow is
+500m apiece, suppose merger will bring after-tax
cash flow of +1100, if the risk stays the same, the
value of the merged firm = 1,100/0.25 =
4,400,increase of 400m.
How May Synergies Be Achieved?
• Synergistic effects can arise from five
sources:
1. Operating economies: This results
from economies of scale in mgt,
marketing , production, or
distribution.
2. Financial economies, including lower
transaction costs and better
coverage by security analysts.
3. Tax effects, where the combined
enterprise pays less in taxes than
the separate firms would pay.
4. Differential efficiency: this implies
that the mgt of one firm is more
efficient and that the weaker firm’s
assets will be more productive after
the merger.
5. Increased market power.
Dubious Reason for Mergers.
1. Risk
reduction
through
diversification: Diversification does
not reduce systematic risk. Risk
reduction is achieved through in
unique risk. Typically investors can
diversify their own portfolios more
easily than firms can.
Types of Mergers
• Horizontal Merger occurs when one
firm combines with another in its line
of business. Eg. is the Daimler
Chrysler merger (find the details).
• Vertical Merger: involves companies
at different stages of production.
Types: forward merger and backward
merger.
• Forward merger occurs when a firm
merges with the main distributor of
its products. Backward merger
happens if a firm merges with the
supplier of its key raw material.
• A Conglomerate merger: involves
companies in unrelated lines of
businesses.
Economic Gains and Costs
• Economic gain or benefit exists if the two
firms are worth more together than as
separate entities.
• GAIN = PVAB – (PVA + PVB)
• If GAIN > 0, then there is economic
justification
• Suppose PVA = $50m; PVB = $60m
• If PVAB is $120m, then the combined is
worth GHC10m more.
Economic Gains and Costs
• Cost: the premium that the buyer
pays over and above the value of the
firm being bought.
• If paying cash, it is defined as:
• COST (PREMIUM) = CASH – VALUE OF
FIRM BOUGHT(PVB)
• Net Present Value to A if A pays cash
to acquire B is NPV = GAIN – COST
• NPV = [PVAB – (PVA + PVB)] – [CASH –
PVB]
• Example: If PVA = $200m; PVB = $50m
and merger will result in a cost saving
with PV of $25m.
• PVAB – (PVA + PVB) = +25m
• PVAB – $(200m + 50m)= +25m
• PVAB = $275m
• Suppose A paid 65m to acquire B,
then
• Cost = $65m – 50m = $15m
• NPV of the transaction = $25 – 15 =
$10m
• Shareholders of B realised $15m
more than the value of their shares
and those of A get $10m more. This
is how the $25m is distributed.
Structuring the Purchase Consideration
Eg: X takes over Y, making it a wholly
owned subsidiary. The table below
contains pre-merger information
concerning X and Y.
Company Company
X
Y
$20
$10
Price per
common share
Number of
25
shares(millions)
Total market
$500
capitalisation
(m)
10
$100
Cash Acquisition
• Suppose X pays 50% premium over
current market value of Y. suppose
further that the NPV of acquiring Y is
$100m. Therefore, the value of Y to X
is 100+100 = 200m.
• The acquisition cost of Y = 150% x 100
= 150m
• The NPV of this option = The value
of Y – the acquisition cost = 200 –
150 = $50m.
• Now, if the market had full access to
all information considered by X’s
Board and took the same view of
the future then, the value of X after
the merger would be:
• Pre-acquisition value of X + value of
Y – Cost of acquisition
= 500+ (200 – 150) = 550m
• Therefore, the stock price would be
$550m/25m shares = $22 (i.e a price
gain of $2 per share)
Share purchase
• To make a stock offer for Y, X will have to issue
new shares worth $150m. Since the current
price of X is $20 per share, X will need to issue
150m/20 = 7.5m new shares. Therefore, the
number of X shares issued and outstanding
after the acquisition is 25m + 7.5m = 32.5m.
• The value of the merged firm is: 500+200 =
700m.
• Thus, price per share = 700/32.5 = $21.54.
Thus the value of Y to X is 7.5m x
21.54=161.55.
Cash vrs. Shares
• The NPV of the Share option is $200m –
161.55m = 38.45m. This is lower than
the $50m shown as the NPV in the cash
offer.
• If we compare the two cases, which one
is better? In the case of cash purchase,
the existing X shareholders get to keep
all of the synergy benefits, whereas in B
they to be shared with the shareholders
of Y.
• In general, stock financing of a
merger is favored by pessimistic
buyer, cash financing by optimistic
buyer.
• Share financing reduces the impact
of over or under valuation.
• DEFENSE STARTEGIES: Refer to the
next two slides
Type of Defense
Description
Shark-repellent charter
amendments:
Staggered board
Pre-offer Defenses
Supermajority
A high percentage of shares is
needed to approve a merger,
typically 80%
Restricted voting rights
Shareholders who own more than a
specified proportion of the target
have no voting rights unless
approved by the target’s board.
Waiting period
Unwelcome acquirers must wait for
a specified number of yrs. before
The board is classified into 3 equal
groups. Only one group is elected
each yr. Therefore the bidder
cannot gain control of the target
immediately.
Others: poison pill
Existing shareholders are issued
rights which, if there is a
significant purchase of shares by a
bidder, can be used to purchase
additional stock in the company at
a bargain price.
Poison put
Existing bondholders (debtholders)
can demand immediate repayment
if there is a change of control as a
result of a hostile takeover.
File suit against bidder for violating
antitrust or securities laws.
Litigation
Asset structuring
Buy assets that bidder does not
want so that it will create an
antitrust problem.
White knight
Getting a 3rd party who is
acceptable to the target firm’s mgt