Calculate the maximum premium that should be paid in a stock acquisition, as well as the earnings per share before and after a merger, the new price of the combined firm, and the change in percentage ownership that will happen as a result of the merger.
Identify two methods commonly used to pay for a target, and the tax and accounting consequences of each.
Discuss the role of the board of directors and shareholders of the target and the board of directors of the acquirer in the merger.
Consider two firms, Alpha, Inc. and Omega Corporation. Both corporations will either make $20 million or lose $10 million every year with equal probability. The firms’ profits are perfectly positively correlated. That is, any year Alpha, Inc. earns $20 million, Omega Corporation also makes $20 million, and the same is true of a losing year. Assume that the corporate tax rate is 34%. What are the total expected after-tax profits of both firms when they are two separate firms? What are the expected after-tax profits if the two firms are combined into one corporation called Alpha-Omega Corporation, but are run as two independent divisions? (Assume it is not possible to carry back or carry forward any losses.)
Let’s start with Alpha, Inc. In the profitable state, the firm must pay corporate taxes, so after-tax profits are $20 × (1 − 0.34) = $13.2 million. No taxes are owed when the firm reports losses, so the expected after-tax profits of Alpha, Inc. are 13.2(0.5) − 10(0.5) = $1.6 million. Because Omega Corporation has identical expected profits, its expected profits are also $1.6 million. Thus, the expected profit of both companies operated separately is $3.2 million.
The merged corporation, Alpha-Omega Corporation, will make $26.4 million after taxes in the profitable state, and will lose $10 million in the unprofitable state. After taxes, expected profits are therefore 26.4(0.5)-20(0.5)=$3.2 million. So Alpha-Omega Corporation has the same after-tax profits as the total standalone after-tax profits of Alpha, Inc. and Omega Corporation.
All else being equal, larger firms are more diversified, and therefore have a lower probability of bankruptcy.
The argument is that with a merger, the firm can increase leverage and thereby lower their costs of capital.
Due to market imperfections like bankruptcy, a firm may be able to increase its debt and enjoy greater tax savings without incurring significant costs of financial distress by merging and diversifying.
Gains must be large enough to offset any disadvantages of running a larger, less focused firm
It is possible to combine two companies with the result that the earnings per share of the merged company exceed the pre-merger earnings per share of either company, even when the merger itself creates no economic value .
The price paid for a target is equal to the target’s pre-bid market capitalization plus the premium paid in the acquisition.
If the pre-bid market capitalization is viewed as the stand-alone value of the target, then from the bidder’s perspective, the takeover is a positive-NPV project only if the premium it pays does not exceed the synergies created.
In September 2001, HP announced that it would purchase Compaq by swapping 0.6325 share of HP stock for each share of Compaq stock.
After the announcement, HP traded for $18.87 per share, while the price of Compaq was $11.08 per share. Thus, Compaq’s share price after the announcement was $0.8553 below the implied value of HP’s offer.
If the acquirer pays for the takeover entirely by exchanging bidder stock for target stock, then the tax liability is deferred until the target shareholders actually sell their new shares of bidder stock.
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 hostile takeover to succeed, the acquirer must go around the target board and appeal directly to the target shareholders.
In a hostile takeover, the acquirer attempts to convince the target’s shareholders to unseat the target’s board by using their proxy votes to support the acquirers’ candidates for election to the target’s board
It is a rights offering that gives the target shareholders the right to buy shares in either the target or an acquirer at a deeply discounted price.
Because target shareholders can purchase shares at less than the market price, existing shareholders of the acquirer effectively subsidize their purchases, making the takeover so expensive for the acquiring shareholders that they choose to pass on the deal.
Often times the target firm is poorly managed, resulting in a low share price. If the corporate raider can take control of the firm and replace management, the value of the firm (and the raider’s wealth) will increase.
The problem is that existing shareholders do not have to invest time and effort, but still participate in all the gains from the takeover that the corporate raider generates, hence the term “free rider problem.”
The corporate raider is forced to give up substantial profits and thus will likely choose not to bother at all.
A situation in which the laws on tender offers allow an acquiring company to freeze existing shareholders out of the gains from merging by forcing non-tendering shareholders to sell their shares for the tender offer price.
The freezeout tender offer has a significant advantage over a leveraged buyout because an acquiring corporation need not make an all-cash offer, but can use shares of its own stock to pay for the acquisition.