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Fundamentals of Corporate Finance/3e,ch22

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  • 1. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-1Chapter Twenty-twoMergers, Acquisitions andTakeovers
  • 2. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-222.1 The Legal Forms of Acquisitions22.2 Regulation of Business Combination22.3 Taxes and Acquisitions22.4 Gains from Acquisition22.5 Some Financial Side-effects of Acquisitions22.6 The Cost of an Acquisition22.7 Defensive Tactics22.8 Some Evidence on Acquisitions22.9 Summary and ConclusionsChapter Organisation
  • 3. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-3Chapter Objectives• Discuss the legal forms of acquisitions.• Understand the legal framework for mergers,acquisitions and takeovers.• Discuss the gains from acquisition.• Explain the financial side-effects of acquisitions.• Calculate the costs and NPV of an acquisition.• Identify and discuss possible defensive tactics to atakeover attempt.
  • 4. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-4Legal Forms of Acquisitions• Merger → complete absorption of one company byanother.• Consolidation → creation of a new firm bycombining two existing firms.• Advantages of mergers and consolidations:– simplicity (buyer assumes all assets and liabilities)– inexpensive.• Disadvantages of mergers and consolidations:– shareholders of both firms must approve– difficulty in obtaining cooperation of target company’smanagement.
  • 5. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-5Legal Forms of Acquisitions• Acquisition of assets → transfer of assets andliabilities of the target company to the acquiringcompany.• Acquisition of shares (tender offer) → acquiresufficient voting shares to gain managementcontrol via a direct public offer for the shares.• Majority control versus effective control.
  • 6. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-6Acquisition Classifications• Horizontal acquisition → between two firms in thesame industry.• Vertical acquisition → the buyer expandsbackwards by acquiring a firm with the source ofraw materials or forwards by acquiring a firm that iscloser in the direction of the ultimate consumer.• Conglomerate acquisition → involves companies inunrelated industries.
  • 7. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-7A Note on TakeoversTakeoversAcquisitionProxy contestGoing private(leveraged buyouts)Merger or consolidationAcquisition of stockAcquisition of assets
  • 8. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-8Takeover Situations• Creeping takeover– Holdings in a target company can be increased by nomore than 3 per cent every six months.• Off market bid– A formal written offer is made to acquire the shares of atarget company.• Market bid– An announcement by a stockbroker that a broking firm willstand in the market to purchase the target company’sshares for a specified price for a specified period.
  • 9. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-9The Legal FrameworkCommon law Enacted law(legislation)Stock ExchangeRulesContract law Law of tortTrade PracticesAct 1974Corporations Act2001Australian SecuritiesCommission Act1989CorporationsRegulations
  • 10. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-10Taxes and Acquisitions• Generally, assets purchased after 19 September1985 are subject to capital gains tax (CGT) whensold.• CGT can be deferred under rollover provisions.• CGT still applies when the consideration is shares,and when more than 50 per cent of pre-19September 1985 shareholders have changed(regardless of purchase date).
  • 11. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-11Gains from Acquisition• Synergy → the value of the combined companies ishigher than the sum of the value of the individualcompanies.• Need to determine incremental cash flows.( )BAABBAABVVVVVVV+−=∆+>
  • 12. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-12Incremental Cash Flows= ∆Revenue – ∆Cost – ∆Tax – ∆Capital requirements• A. Increased revenues1. Gains from better marketing efforts.2. Strategic benefits—‘beachhead’ into new markets.3. Increased market power—monopoly.• B. Decreased costs1. Economies of scale.2. Economies of vertical integration.3. Complementary resources.
  • 13. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-13Incremental Cash Flows• C. Tax gains1. Use of net operating losses.2. Use of excess or unused franking credits.3. Use of unused debt capacity.4. Asset revaluations.• D. Changing capital requirements1. Reduced investment needs.2. More efficient asset management.3. Sell redundant assets.
  • 14. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-14Mistakes to Avoid• Do not ignore market values.• Estimate only incremental cash flows.• Use the correct discount rate.• Be aware of transactions costs.
  • 15. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-15Acquisitions and EPS GrowthPizza Shack and Checkers Pizza are merging to formStop ’n’ Go Pizza. The merger is not expected tocreate any additional value. Stop ‘n’ Go, valued at$1 875 000, is to have 125 000 shares outstanding at$15 per share.
  • 16. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-16Acquisitions and EPS GrowthBefore and after merger financial positions100 000 Stop ’n’ Go shares to Pizza Shack holders25 000 Stop ’n’ Go shares to Checkers holders
  • 17. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-17Acquisitions and EPS Growth• EPS has increased (and the P/E ratio hasdecreased) because the total number of shares isless.• The merger has not ‘created’ value.
  • 18. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-18Diversification• Does not create value in a merger.• Is not, in itself, a good reason for a merger.• Reduces unsystematic risk.BUT• Shareholders can do this for themselves moreeasily and less expensively.
  • 19. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-19The Cost of an Acquisition• The net incremental gain from a merger of Firms A and B is:∆V = VAB – (VA + VB)• The total value of Firm B to Firm A is:VB* = VB + ∆V• The NPV of the merger is:NPV = VB* – Cost to Firm A of the acquisition• The cost of the acquisition to Firm A depends on the mediumof exchange used to acquire Firm B—cash or shares.
  • 20. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-20The Cost of an Acquisition• Whether cash or shares are used to finance theacquisition depends on the following factors:– Sharing gains: If cash is used, the selling firm’sshareholders will not participate in the potential gains (orlosses) from the merger.– Control: Control of the acquiring firm is unaffected in acash acquisition. Acquisition with voting shares may haveimplications for control of the merged firm.
  • 21. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-21Example—Cash or Shares?Pre-merger information for Firm A and Firm B:Both firms are 100 per cent equity financed.The estimated incremental value of the acquisition is$500.
  • 22. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-22Example—Cash or Shares?(Continued)• Firm B has agreed to a sale price of $675, payablein cash or shares.• The value of Firm B to Firm A is:• How much does Firm A have to give up?1060$560$500$VVV BB=+=+∆=∗
  • 23. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-23Example—Cash Acquisition• Cost of acquiring Firm B is $675.• NPV of the cash acquisition is:• The value of Firm A after the merger is:• Price per share after the merger is $18.20.385$675$1060$CostNPV *VB=−=−=( )( ) 2185$675$1060$1800$CostVVV BAAB=−+=−∗+=
  • 24. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-24Example—Share Acquisition• The value of the merged firm:• Firm A must give up $675/$15 = 45 shares.• After the merger there will be 165 sharesoutstanding, valued at $17.33 per share.2860$500$560$1800$VVVV BAAB=++=∆++=
  • 25. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-25Example—Share Acquisition• True cost of the acquisition:45 shares × $17.33 = $779.85• NPV of the merger to Firm A:• Cash acquisition preferred (higher NPV).15280$85779$1060$CostNPV..*VB=−=−=
  • 26. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-26Defensive TacticsManagers who believe their firms are likely tobecome takeover targets and who wish to fend offunwanted acquirers often implement one or moretakeover defences. These defensive tactics takeseveral forms:– Friendly shareholders offer the best defence.– Poison pills—designed to ‘repel’ takeover attempts.– Share rights plans—allow existing shareholders topurchase shares at some fixed price in the event of atakeover bid.– Going private and leveraged buyouts—the publicly ownedshares in a firm are replaced with complete equityownership by a private group (often financed by debt).
  • 27. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-27Terminology of Defensive Tactics• Golden parachutes—compensation to top-levelmanagement.• Poison puts—purchase securities back at a setprice.• Crown jewels—selling off of major assets.• White knights—acquisition by a ‘friendly’ firm.• Lockups—option for a ‘friendly’ firm to purchaseshares or assets at a fixed price.• Shark repellant—designed to discourage unwantedmergers.
  • 28. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-28Evidence on Acquisitions• Shareholders of target companies involved insuccessful takeovers gain substantially.• Abnormal gains of around 25 per cent reflectmerger premium.
  • 29. Copyright  2004 McGraw-Hill AustraliaPty Ltd22-29Evidence on Acquisitions• Shareholders of bidding firms involved insuccessful takeovers only experience gains of 5per cent. There are a variety of explanations forthis:– Overestimated anticipated gains– Scale effect (bidders usually larger than targets)– Agency problem– Competitive market for takeovers– Gains already reflected in bidder’s price (no newinformation)