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CHAPTER 28 Mergers and Acquisitions

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CHAPTER 28 Mergers and Acquisitions CHAPTER 28 Mergers and Acquisitions Chapter Synopsis 28.1 Background and Historical Trends The takeover market experiences merger waves that are generally characterized by a typical type of deal. The increase in activity in the 1960s is known as the conglomerate wave because firms typically acquired firms in unrelated businesses. The 1980s were known for hostile takeovers in which acquirers often purchased poorly performing conglomerates and sold off the individual business units. The 1990s wave is characterized by strategic, global deals involving companies in related businesses often designed to create strong firms on a scale that would allow them to compete globally. Merger activity is greater during economic expansions and during bull markets. Many of the same technological and economic conditions that lead to a growing economy also apparently motivate managers to restructure assets through mergers and acquisitions. 28.2 Market Reaction to a Takeover Most acquirers pay a substantial acquisition premium over the pre-takeover announcement price of the target firm. In mergers between 1973 and 1998, target shareholders experienced an average gain of 16% while acquirer shareholders have an average return of close to 0%. In tender offers between 1968 and 2001, target shareholders experience an average gain of 30% while acquirer shareholders have an average return of close to 0%. ©2011 Pearson Education 338 Berk/DeMarzo • Corporate Finance, Second Edition 28.3 Reasons to Acquire Synergies are by far the most common justification that bidders give for the premium they pay for a target. Such synergies usually fall into two categories: cost reductions and revenue enhancements. Cost-reduction synergies are more common and easier to achieve because they generally translate into layoffs of overlapping employees and elimination of redundant resources. Revenue-enhancement synergies, however, are much harder to predict and achieve. Specific sources of value may include the following. Economies of scale and scope. Economies of scale occur when the average total cost of production decreases as output increases. Economies of scope are savings that come from combining the production, marketing, and distribution of different types of related products. Vertical integration refers to the combination of two companies in the same industry that make products required at different stages of the production cycle. Expertise. Firms may use acquisitions to acquire expertise in particular areas to compete more efficiently. Monopoly gains. Merging with or acquiring a major rival may enable a firm to substantially reduce competition within the industry and thereby increase profits. Society as a whole bears the cost of monopoly strategies, so most countries have antitrust laws that limit such activity. Efficiency gains may be achieved through the elimination of duplication of the costs of running the firm. Acquirers also often argue that they can run the target firm more efficiently than existing management could. Operating losses. When a firm makes a profit, it must pay taxes on the profit. However, when it makes a loss, the government does not rebate taxes. Thus, a conglomerate may have a tax advantage over a single-product firm simply because losses in one division can offset profits in another division. Diversification. Since it is cheaper for investors to diversify their own portfolios than to have the corporation do it through acquisition, the only class of stockholders who can benefit from the diversification a merger generates are managers and other employees who bear the idiosyncratic risk of firm failure and may not hold well-diversified portfolios because they own a large amount of company stock. Lower cost of debt or increased debt capacity. All else being equal, larger firms, because they are more diversified, have a lower probability of bankruptcy. Consequently, they may have a higher debt capacity and a potentially lower borrowing cost. 28.4 The Takeover Process An acquisition is only a positive-NPV project if the premium paid does not exceed the expected synergies. Valuing a target using comparable firm valuation multiples does not directly incorporate the operational improvements and other synergistic efficiencies that the acquirer intends to implement. Thus, a discounted cash flow valuation based on a projection of the expected cash flows that will result from the deal should be completed. A tender offer is a public offer to purchase specified number of shares at a set price for a specified time period. A public target firm’s board may not recommend that existing shareholders tender their shares, even when the acquirer offers a significant premium over the pre-offer share price. There is also the possibility that regulators might not approve the ©2011 Pearson Education Berk/DeMarzo • Corporate Finance, Second Edition 339 takeover. Because of this uncertainty about whether a takeover will succeed and the lapse of time when it will be accomplished, the market price does not rise by the amount of the premium when the takeover is announced. In a cash transaction, the bidder simply pays for the target, including any premium, in cash. In a stock-swap transaction, the bidder pays for the target by issuing new stock and exchanges it for target stock. The price offered is determined by the exchange ratio—the number of bidder shares received in exchange for each target share. A stock-swap merger is positive NPV if: P ⎛⎞S Exchange Ratio < T ⎜⎟1+ PTA ⎝⎠ where PT is the price of the target, PA is the price of the acquirer, S is the synergies in the deal, and T is the value of the target. Once a tender offer is announced, the uncertainty about whether the takeover will succeed adds volatility to the stock price. Traders known as risk-arbitrageurs speculate on the outcome of the deal. This potential profit arises from the difference between the target’s stock price and the implied offer price, which is referred to as the merger-arbitrage spread. However, it is not a true arbitrage opportunity because there is a risk that the deal will not go through. How the acquirer pays for the target affects the taxes of both the target shareholders and the combined firm. Any cash received in full or partial exchange for shares triggers an immediate tax liability for target shareholders. Target shareholders must pay a capital gains tax on the difference between the price paid for their shares in the takeover and the price they paid when they first bought the shares. If the acquirer pays for the takeover entirely by exchanging bidder stock for target stock, then the tax liability is generally deferred until the target shareholders actually sell their new shares of bidder stock. If the acquirer purchases the target assets directly (rather than the target stock), then it may be able to step up the book value of the target’s assets to the purchase price. This higher depreciable basis reduces future taxes through larger depreciation charges. Further, any goodwill created may be amortized for tax purposes over 15 years. The same treatment applies to a forward cash-out merger, where the target is merged into the acquirer and target shareholders receive cash in exchange for their shares. Stock-swap mergers allow the target shareholders to defer their tax liability on the part of the payment made in acquirer stock, but they do not allow the acquirer to step up the book value of the target assets or amortize goodwill for tax purposes. While the method of payment (cash or stock) affects how the value of the target’s assets is recorded for tax purposes, it does not affect the combined firm’s financial statements for financial reporting. The combined firm must mark up the value assigned to the target’s assets on the financial statements by allocating the purchase price to target assets according to their fair market value. If the purchase price exceeds the fair market value of the target’s identifiable assets, then the remainder is recorded as goodwill and is examined annually by the firm’s accountants to determine whether its value has decreased. For a merger to proceed, both the target and the acquiring board of directors must approve the deal and put the question to a vote of the shareholders of the target and generally shareholders of the acquiring firm as well. ©2011 Pearson Education 340 Berk/DeMarzo • Corporate Finance, Second Edition 28.5 Takeover Defenses A poison pill is a rights offering that gives existing target shareholders the right to buy shares in either the target or the acquirer at a deeply discounted price once certain conditions are met. Because target shareholders can purchase shares at less than the market price, existing shareholders of the acquirer effectively subsidize their purchases. This subsidization makes the takeover so expensive for the acquiring shareholders that they choose not to pursue the deal unless the poison pill is removed, as often happens. About two-thirds of public companies have a staggered (or classified) board in which only a fraction, say one-third, of the directors are up for election each year. Thus, even if the bidder’s candidates win board seats, it will control only a minority of the target board. The length of time required to get control of the board can deter a bidder from making a takeover attempt when the target board is staggered. Most experts consider a poison pill combined with a staggered board to be the most effective defense available to a target company. When a hostile takeover appears to be inevitable, a target company will sometimes look for a white knight, or an alternate company to acquire it. One variant on the white knight defense is the white squire defense, in which a large investor or firm agrees to purchase a substantial block of shares in the target with special voting rights.
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