1FIN B386F Financial Decision Making
Financial Decision Making
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1FIN B386F
Financial Decision Making
Learning Objectives Outline
• -
2
Merger &
Acquisition
3 Legal
procedures of Acquisition
3 Types of Acquisition Valuation of Synergy benefits
from Acquisition Synergy benefits:
4 main sources Financing for Acquisition
By Cash offer
By Share offer
Dubious reasons:
EPS growth &DiversificationDivestitures &Corporate
Restructuring
4 Types of Divestitures Reasons for
Divestitures
Reasons for failure
Acquisition
Defensive Tactics
Takeovers – The Market for Corporate Control
There are 3 ways to change the management control of a firm.
These are:
a)Acquisition: The purchase of one firm by another in a merger or acquisition
b)Proxy Contest: This is an attempt to gain control of a firm by soliciting enough
stockholder votes to replace existing management
c)Going Private (Leverage buyout): A leverage buyout of a firm by a private group of
investors (When this group is led by the company’s management, the acquisition is
called a management buyout MBO)
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Mergers and Acquisitions
Three basic legal procedures one firm can use to acquire another firm:
1. Merger or consolidation
2. Acquisition of stock
3. Acquisition of assets
These forms are different from a legal standpoint, but the financial press
frequently does not distinguish between them
• Merger is often used regardless of actual form of the acquisition
• Acquiring firm is referred to as the bidder, the company that offers to
distribute cash or securities to obtain the stock or assets of another
company
• Firm that is sought (and perhaps acquired) is called the target firm
• Cash or securities offered to the target firm are the consideration in
the acquisition
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Mergers and Acquisitions
Merger is the complete absorption of one company by another, wherein the acquiring
firm retains its identity and the acquired firm ceases to exist as a separate entity. The
bidder remains and the target ceases to exist.
Consolidation is a merger in which an entirely new firm is created and both the
acquired firm and the acquiring firm cease to exist. A new firm is created. Joined firms
cease their previous existence.
The rules for mergers and consolidation ae basically the same. Acquisition by merger
or consolidation results in a combination of the assets and liabilities of acquired and
acquiring firms; the only difference lies in whether or not a new firm is created.
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Company A
Company B
Company A
Company B ceases to exist
Company A
Company B
Company C
Company A & B no longer exist
Mergers and Acquisitions
Some advantages and some disadvantages of using a merger:
Primary advantage is that a merger is legally simple and does not cost as
much as other forms of acquisition
• Firms agree to combine their entire operations, so there is no need to
transfer title to individual assets of the acquired firm to the acquiring firm
Primary disadvantage is that a merger must be approved by a vote of the
stockholders of each firm
• Typically, two-thirds (or more) of the share votes are required for approval
and obtaining the necessary votes can be time-consuming and difficult.
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Acquisition of stock
Another way to acquire another firm is to purchase the firm’s voting stock
with an exchange of cash, shares of stock, or other securities
Process will often start as private offer from management of one firm to that
of another.
Tender offer is a public offer by one firm to directly buy the shares of
another firm
• Communicated to the target firm’s shareholders by public
announcements such as those made in newspaper advertisements
• Tender offer is frequently contingent on the bidder’s obtaining some
percentage of the total voting shares
• Shareholders who choose to accept the offer tender their shares by
exchanging them for cash or securities (or both), depending on the offer
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Acquisition of stock
Some factors involved in choosing between an acquisition by stock and a
merger:
• In an acquisition by stock, no shareholder meetings must be held and no
vote is required
− If the shareholders of the target firm don’t like the offer, they are not
required to accept it and need not tender their shares
• In an acquisition by stock, the bidding firm can deal directly with the
shareholders of the target firm by using a tender offer
• Acquisition is occasionally unfriendly.
− In such cases, a stock acquisition is used to circumvent the target firm’s
management, which is usually actively resisting acquisition
• Frequently, a significant minority of shareholders will hold out in a tender
offer; target firm cannot be completely absorbed when this happens, and
this may delay realization of merger benefits or be costly in some other way
• Complete absorption of one firm by another requires a merger
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Acquisition of assets
A firm can effectively acquire another firm by buying most or all of its assets
• Target firm will not necessarily cease to exist; it will have just sold off
its assets
• “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
• Advantage to this approach is that there is no problem with minority
shareholders holding out
• Disadvantage is that the acquisition of assets may involve transferring
titles to individual assets, and the legal process of transferring assets
can be costly
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Types of Acquisition
Financial analysts typically classify acquisitions into three types:
1. Horizontal acquisition is an acquisition of a firm in the same industry
as the bidder
• One risk in a horizontal merger is antitrust regulations
2. Vertical acquisition involves firms at different steps of the production
process
3. Conglomerate acquisition occurs when the bidder and the target
firm are in unrelated lines of business
• Popular in the technology area
Firms don’t have to merge to combine their efforts
• Strategic alliance is an agreement between firms to cooperate in
pursuit of a joint goal
• Joint venture is typically an agreement between firms to create a
separate, co-owned entity established to pursue a joint goal
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A diagram illustrating horizontal integration and contrasting it with
vertical integration.
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Forward vertical integration when it
controls distribution centers and retailers
where its products are sold.
Backward vertical integration when it
controls subsidiaries that produce some
of the inputs used in the production of its
products.
A diagram illustrating horizontal integration and contrasting it
with vertical integration.
Types of Acquisition
Questions:
Are the following hypothetical mergers horizontal, vertical or conglomerate?
a) IBM acquires the computer manufacturer Lenovo
Horizontal merger. IBM is in the same industry as Lenovo
b) Lenovo acquires Safeway ( a supermarket chain)
Conglomerate merger. Lenovo and Safeway are in different industries.
c) Safeway acquires Campbell Soup
Vertical merger. Safeway is expanding backward to acquire one of its suppliers, Campbell
Soup.
d) Campbell Soup acquires IBM.
Conglomerate merger. Campbell and IBM are in different industries.
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Why might mergers and acquisitions be beneficial?
Synergy Effect ?
• The whole is worth more than the sum of the parts
• Some mergers create synergies because the firm can either cut costs
or use the combined assets more effectively
• This is generally a good reason for a merger
Examine whether the synergies can create enough benefit to justify
the cost for the following 4 basic categories.
a) Revenue enhancement
b) Cost reduction
c) Lower taxes
d) Reduction in capital needed
Synergy
Suppose Firm A is contemplating acquiring Firm B
• Successful merger requires value of the whole (i.e., combined firm) exceed
the sum of the parts (i.e., values of separate firms)
If VAB is the value of the merged firm, and VA and VB are the values of the
separate firms, the merger makes sense only if:
➢VAB > VA + VB (The whole is more than the sum of the parts)
Difference between the value of the combined firm and the sum of the values
of the firms as separate entities is the incremental net gain from the
acquisition, ΔV:
➢ΔV = VAB − (VA + VB)
Synergy is the positive incremental net gain associated with the combination
of two firms through a merger or acquisition
• When ΔV is positive, the acquisition is said to generate synergy
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Synergy
If Firm A buys Firm B, it gets a company worth VB plus the incremental gain,
ΔV, so the value of Firm B to Firm A (VB
*) is:
Value of Firm B to Firm A (Acquiring firm) = VB
* = ΔV + VB
VB
* can be determined in two steps:
1. Estimating VB
2. Estimating ΔV
If B is a public company, its market value as an independent firm under
existing management (VB) can be observed directly, but if Firm B is not
publicly owned, its value will have to be estimated based on similar
companies that are publicly owned
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Synergy
To determine the incremental value of an acquisition, we need to know the
incremental cash flows, ΔCF, the cash flows for the combined firm less what A
and B could generate separately:
ΔCF = ΔRevenue − ΔCost − ΔTax − ΔCapital requirements
Merger will make sense only if one or more of these cash flow components
are beneficially affected by the merger.
Possible cash flow benefits of mergers and acquisitions fall into four basic
categories:
a) Revenue enhancement
b) Cost reductions
c) Lower taxes
d) Reductions in capital needs
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P/L
B/S
Revenue Enhancement
Marketing gains might occur as a result of improvements in the following areas as a
result of changes in advertising efforts, changes in the distribution network, changes
in the product mix.
a) Previously ineffective media programming and advertising efforts
b) A weak existing distribution network
c) An unbalanced product mix
Strategic benefits are opportunities 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
• Beachheads – acquisitions that allow a firm to enter a new industry that may
become a platform for further expansion
Increases in market power (reduction in competition or increase in market share) may
result in profit enhancements through higher prices.
• Mergers that substantially reduce competition may be challenged by U.S.
Department of Justice or Federal Trade Commission on antitrust grounds
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Cost Reductions
Economies of scale relate to the average cost per unit of producing goods and services
• Ability to produce larger quantities while reducing the average per unit cost
• Most common in industries that have high fixed costs
• Spreading overhead refers to sharing central facilities such as corporate
headquarters, top management, and computer services
Economies of vertical integration have a main purpose of making it easier to
coordinate closely related operating activities
• Coordinate operations more effectively
• Reduced search cost for suppliers or customers
• For example, most forest product firms that cut timber also own sawmills and
hauling equipment
Complementary resources are characterized by some firms acquiring others to make
better use of existing resources or to provide the missing ingredient for success
• For example, a ski equipment store may merge with a tennis equipment store
to produce more even sales over both the winter and summer seasons,
thereby better using store capacity
• Anther example: banks that allow insurance or stock brokerage services to be
sold on premises
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Lower Taxes
Possible tax gains from an acquisition include the following:
a) Take advantage of net operating losses
− Carry-backs and carry-forwards
− Merger may be prevented if the tax authorities believe the sole purpose is
to avoid taxes
b) Unused debt capacity
− Allows merged firms to borrow more giving rise to tax shields
c) Surplus funds
− Under free cash flow, firms are encouraged to pay dividends to remove the
free cash from the firm. This method may result in shareholders having to
pay more taxes. Using the excess cash for acquisitions avoids having to pay
additional taxes.
• Net operating losses (NOL) are tax losses a firm cannot use because they
lost money on a pretax basis (and will not pay taxes)
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Reductions in Capital needs
All firms must invest in working capital and fixed assets to sustain an efficient
level of operating activity
‒ A merger may reduce the required investment in working capital and fixed
assets relative to the two firms operating separately
Acquiring firms may be able to manage existing assets more effectively under
one umbrella
‒ Can occur with a reduction in working capital resulting from more efficient
handling of cash, accounts receivable, and inventory
Acquiring firm may also sell off certain assets that are not needed in the
combined firm
‒ Some assets may be sold if they are redundant in the combined firm (this
includes reducing human capital as well)
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Analytical income statement
Sales
- Total variable costs
- Fixed costs
EBIT (Operating income)
- Interest
EBT
- Taxes
Net income
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Revenue Enhancement
Cost
Reductions
Lower Taxes
Dubious reason for EPS Growth
• Mergers and acquisition may give the appearance of growth in EPS without
actually changing cash flows.
• Buying a firm with a lower P/E ratio can increase earnings per share. But the
increase should not result in a higher share price.
• If there are no synergies or other benefits to the merger, then the growth in EPS is
not true growth.
• Example:
• Suppose Global Resources, Ltd., acquires Regional Enterprises, but the merger
creates no additional value; after the merger we should have the following
information if the market is smart.
• Global will have 140 shares outstanding
• Market value of the combined firm is $3,500
• Earnings per share of the merged firm are $1.43
• Because the stock price of Global after the merger is the same as before the
merger, the price-earnings ratio must fall.
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Dubious reason for EPS Growth
Acquisition can create appearance of EPS growth
• Suppose Global Resources, Ltd., acquires Regional Enterprises.
• The financial positions of both firms before the acquisition is shown below.
• Assume the merger creates no additional value, so the combined firm (Global Resources after
acquiring Regional) has a value that is equal to the sum of the values of two firms before the
merger.
• Before the merger, both firms have 100 shares outstanding. However, Global sells for $25 per
share versus a price of $10 per share for Regional.
• Global acquires Regional by exchanging 1 of its share for every 2.5 shares in Regional. Because
there are 100 shares in Regional, this will take 100/2.5 = 40 shares in all.
• After the merger, Global will have 140 shares outstanding and several things will happen.
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Dubious reason for EPS Growth
The market value of the combined firm is $3,500, that is $2,500 plus $1,000. This is equal to the
sum of the values of these 2 firm before the merger and the price per share $3,500/140 = $25
If the market is “smart”, it will realize that the combined firm is worth the sum of the values of
these 2 separate firms.
The earnings per share of the merged firm is $1.43 ($200/140) and the acquisition enables Global
to increase its earnings per share from $1 to $1.43, an increase of 43 %.
Because the stock price of Global after the merger is the same as before the merger (the merger
creates no additional value), the price-to-earnings ratio must fall to 17.50, that is, $25/$1.43 and
recognizes that the total market value has not been altered by the merger.
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P/E must fall
$200/140
$3,500/140
$2,500+ $1,000
Dubious reason for EPS Growth
If the market is “fooled”, it might mistake the 43% increase in earnings per share for true growth.
In this case, the PE ratio of Global may not fall after the merger and remains equal to 25.
Because the combined firm has earnings of $200, the total value of the combined firm will
increase to $5,000 (25 x $200).
The per share value for Global will increase to $35.71 ($5,000/140).
This is earnings growth is illusion only as can be seen, the merger does not create value.
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Bootstrapping
In the previous example, Global takes over Regional and it is assumed that the post
acquisition value of the combined company can be estimated by applying Global’s P/E
ratio to be combined company’s earnings.
This is known as bootstrapping and it is based on that the market will assume that the
management of the acquiring company will be able to apply common approach to
both companies after the takeover, thus improving the performance of the acquired
company by using the methods that they have been using on their own company
before the takeover.
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Dubious reason for Diversification
• Diversification is commonly mentioned as a benefit of a merger, but
diversification is not a good reason for a merger because:
• Diversification doesn’t create value itself because diversification reduces
unsystematic, not systematic risk.
• Value of an asset depends on its systematic risk, and systematic risk is
not directly affected by diversification
• Because the unsystematic risk is not especially important, there is no
particular benefit from reducing it
• Stockholders can get all the diversification they want by buying stock in
different companies. They can diversify their own portfolio more cheaply
than a firm can diversify by acquisition.
• As a result, they won’t pay a premium for a merged company for the
benefit of diversification
• Reducing unsystematic risk benefits bondholders by making default less
likely.