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2020External GrowthThrough Mergers

External GrowthThrough Mergers

Prepared by:

Michel PaquetSAIT Polytechnic

©2009 McGraw-Hill Ryerson Limited

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Chapter 20 - Outline

• Business Combinations

• Negotiated versus Tendered Offers

• Motives for Business Combinations

• Terms of Exchange

• Accounting, Financial and Organizational Considerations in Mergers and Acquisitions

• Summary and Conclusions

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Learning Objectives

1. Outline some defensive measures taken to avoid an unfriendly takeover. (LO1)

2. Identify the motives for mergers and divestitures, including financial considerations and the desire to increase operating efficiency. Also, perform an NPV analysis for a merger proposal. (LO2)

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Learning Objectives

3. Explain acquisition through cash purchases or by one company exchanging its shares for another company’s shares. (LO3)

4. Evaluate the impact of the merger on earnings per share and share value. (LO4)

5. Discuss the diversification benefits of a merger. (LO5)

6. Outline the reasons for using a holding company. (LO6)

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3 Types of Mergers

Horizontal Merger:– unites direct competitors

– e.g. 2 competing shoe companies combine

– closely regulated by governments as reducing competition

Vertical Merger:– unites buyers and sellers

– e.g. a shoe manufacturer buys a leather producer

Conglomerate Merger:

– merging of firms in totally unrelated industries

– e.g. a shoe company joins with a beverage company

LO1

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Table 20-1

Largest mergers and acquisitions Value

Buyer Acquired Company ($ U.S. billions) Year

1. America Online . . . . Time Warner $183 20002. Vodaphone Airtouch . . Mannesmann 149 20003. Bell Atlantic . . . . . GTE 85 20004. SBC Communications . Ameritech 81 19995. Exxon . . . . . . . . Mobil 79 19986. Royal Dutch petroleum Shell Transport and Trading 75 20047. Vodaphone . . . . . Airtouch 74 19997. Pfizer . . . . . . . Warner-Lambert 73 20008. AT&T Inc... . . . . . Bell South 73 200610. Comcast . . . . . . . AT&T Broadband 72 2001

LO1

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Table 20-2Largest mergers and acquisitions by Canadian companies

Merger Partners Value (Cdn. billions) Year

1. BCE . . . . . . . . Ontario Teachers’ Pension Plan $51.7 20082. RioTinto . . . . . . Alcan 43.9 20073. Inco . . . . . . . . . CVRD 19.9 20064. Falconbridge . . . . Xstrata 19.2 20065. Manulife Financial . .John Hancock 18.9 20046. Thomson . . . . . . Reuters 18.2 20077. Seagram . . . . . . Polygram 15.6 1998

LO1

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Measures to Avoid Takeovers

1. White Knight:- a friendly company agreeing to bid a higher price for

the potential takeover target

2. Crown Jewels:- a prized division or asset sold by the target making the takeover less

attractive

3. Targeted Repurchase (also called “Greenmail”):- an offer by the target to buy back the shares already purchased by the

acquiring company by paying a premium

LO1

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Measures to Avoid takeovers

4. Golden Parachutes:- Contracts to pay existing management rather large sums

of money if the company is taken over and they lose

their jobs

5. Taking on More Debt:- Taking on more debt making the target more expensive to acquire

6. Poison Pills (also known as Shareholders’ Rights Plans):- a plan allowing the targeted firm’s all shareholders excluding the potential

acquirer to buy newly issued shares at very low price

LO1

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Business Combinations

• Legal definition of amalgamation:- a statutory combination under one of the provincial

corporations or companies acts, the Canada Corporations Act, or the Canada Business Corporations Act

• Merger (and acquisition) refers to a transaction by which two or more companies are combined either under a statutory amalgamation or by ownership, that is: - one firm buys a majority or all of the voting shares of

another firm

LO2

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Financial Motives for Business Combinations

• To reduce risk through diversification

• To improve financing posture- Larger firms enjoy greater access to capital- Greater financing capability may be achieved if the acquired firm has a strong

cash position or low debt-equity ratio

• To obtain tax loss carry-forward benefit

• To gain synergistic effect- Synergy: the whole is greater than the sum of the parts (“2 + 2 = 5”)- Overlapping functions in production and marketing are eliminated- Engineering and administrative capabilities are meshed

LO2

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Negotiated versus Tendered Offers• Mergers can be either friendly or hostile.• Negotiated Offer: - a deal negotiated friendly between participating

corporations - agreed upon by all sides• Tendered Offer: - the buyer’s proposal not accepted by the potential

seller’s management and board of directors - the offer made by the buyer asking the potential seller’s

shareholders to tender (i.e. sell) their shares to the buyer - a hostile takeover bid

LO2

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Non-financial Motives for Business Combinations

• To expand management and marketing capabilities

• To acquire new products

LO2

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Motives of Selling Shareholders

• To receive the acquiring company’s shares

• To diversify their holdings into many new investments

• To escape the bias against smaller businesses

LO2

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Terms of Exchange

• the price to be paid for a potential acquisition• factors to consider including: earnings, dividends,

growth potential• depend on the method of payment

A. Cash Purchase- can be viewed as a capital budgeting decision

B. Stock-for-Stock Exchange

- a trade-off between an immediate gain or dilution in EPS and future growth

LO3

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SmallExpandCorporation Corporation

Total earnings. . . . . . . . . $200,000 $500,000

Shares of stock outstanding . . . . . . 50,000 200,000

Earnings per share . . . . . . $4.00 $2.50

Price-earnings ratio (P/E) . . . 7.5x 12x

Market price per share . . . . $30.00 $30.00

Table 20-3Financial data on potential merging firms

LO4

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Table 20-4 Post-merger earnings per share

Total earnings: Small ($200,000) + Expand ($500,000) . . . $700,000

Shares outstanding in surviving corporation: Old (200,000) + New (50,000) . . . . . . . . . . . . . 250,000

New earnings per share for Expand Corporation = = $2.80$700,000

250,000

LO4

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FIGURE 20-1Risk reduction: portfolio benefits

LO4

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Accounting Considerations in Mergers and Acquisitions

A merger can be treated as either a pooling of interest or a purchase of assets1. Pooling of Interest- companies combine their financial statements- no goodwill is created2. Purchase of Assets- The transaction is treated as a purchase of an asset.- Any excess of purchase price over book value must be

recorded as goodwill.- Goodwill can not be amortized, but can be written down if

the fair value drops.

LO5

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Financial Considerations in Mergers and Acquisitions

1. Market Value Maximization– To determine the potential impact on shareholder value in the

new firm

2. Premium Offers and Stock Price Movements– Acquiring firms often offer 5 to 50 percent premium to get the

targets.– High premiums are justified if synergy can be realized.– Acquirees have superior stock price performance.

3. Mergers and the Market for Corporate Control– Mergers are an effective way of forcing agent managers to

maximize shareholder wealth.

LO5

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Organizational Considerations in Mergers and Acquisitions

• A holding company is one that has control over one or more other firms.

• It allows effective corporate control with minimal equity investments.

• It also benefits from the isolation of the legal risks of the firms.

• Drawbacks are:- magnifying poor returns- complicating administrative policies and procedures- depressing share price

LO6

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Summary and Conclusions

• Firms grow externally through mergers and acquisitions.• Mergers can be friendly negotiated or become hostile.• The targeted firm has plenty of defensive tactics at its

disposal such as white knight and poison pills.• Achieving synergistic effect is the greatest motive for a

merger.• There are other financial and non-financial motives for

firms to merger.

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Summary and Conclusions• A acquiring firm may pay cash (cash purchase) or its

own stock (stock-for-stock exchange) for an acquisition.

• The method of payment has financial implications for both the acquirer and the acquiree.

• The acquiree’s shareholders appear to benefit from a merger due to high premium and superior stock price performance.

• The acquirer’s shareholders tend to gain over a long run.