Mergers and Acquisitions

Introduction When one company buys another. It

is making an investment.Acquisition of one firm by another

is, of course, an investment made under uncertainty.

Go ahead with the purchase, if it makes a net contribution to shareholders wealth.

When a firm is taken over, its management is usually replaced.

MergerA transaction where two firms agree to integrate their operations on a relatively coequal basis because they have resources and capabilities that together may create a stronger competitive advantage

AcquisitionA transaction where one firm buys another firm with the intent of more effectively using a core competence by making the acquired firm a subsidiary within its portfolio of businesses

TakeoverIf management of one firm believes that another company’s management is not acting in interest of investors, it can go over heads of that firm’s management and make tender offer directly to its stockholders.

The Merger MarketTools Used To Acquire Companies

Proxy Contest

Acquisition

Leveraged Buy-Out

Management Buy-Out

Merger

Tender Offer

Proxy contestTakeover attempt in which

outsiders compete with management for shareholders votes (so called proxy fight)

A proxy is the right to vote another shareholder’s share

In a proxy contest, outsiders would like to take control with electing new board members

Mergers and Acquisitions

Three ways one firm to acquire another firm:

◦Merger◦Tender offer◦Acquisition

MergerCombination of two firms into one, with the

acquirer assuming assets and liabilities of the target firm.

Merger must have approval of more than 50% of shareholders

Horizontal merger-take place between two firms in the same line of business (two banks)

Vertical merger-involves firms at different stages of production (raw materials and consumer products)

Sensible Reasons for Mergers

Economies of ScaleA larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units.Opportunity to spread fixed costs across a larger volume of output.

$ $$Reduces

costs

Sensible Reasons for Mergers

Combining Complementary ResourcesUsually small firms are acquired by large firms can be part of success too.Merging may results in each firm filling in the “missing pieces” of their firm with pieces from the other firm.

Firm A

Firm B

Dubious Reasons for Mergers

Diversification reduces risk, Diversification is easier and

cheaper for shareholders than for the company

Investors should not pay a premium for diversification since they can do it themselves

Evaluating MergersQuestions

◦Is there an overall economic gain to the merger? (Value enhancing, worth two firms than apart)

◦Do the terms of the merger make the company and its shareholders better off?

PV(AB) > PV(A) + PV(B)

Evaluating MergersEconomic Gain

Economic Gain = PV(increased earnings)

= New cash flows from synergies

discount rate

Evaluating MergersExample - Given a 20% cost of funds,

what is the economic gain, if any, of the merger listed below?

40 432Earnings

13216118Costs Operating

172 20150Revenues

CombinedTargetcoFoods ABC

200$.20

40=Gain Economic

Additional value is the basic motivation for the merger.

Operating costs reduced as combining companies marketing, administration and distribution departments.

Projected revenues will be increased

Increased earnings are the only synergy to be generated by the merger.

Tender offerIt is a takeover attempt in which

outsiders directly offer to buy the stock of the firm’s shareholders

With this method acquiring firm (investors) can bypass the target firm’s management

Leveraged Buy-Outs

LBO-Acquisition of a firm by private group of investors using borrowed debt. Unique Features of LBOs:-

Large portion of buy-out financed by debt

Shares of the LBO no longer trade on the

open market