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  1. 1. Chapter 19 - Mergers and Acquisitions, Rose & Hudgins, 7th ed. Reasons for mergers - Increase expected value by: 1. increasing expected earnings (increase revenues or decrease costs) 2. reducing risk through diversification 3. tax benefits – acquiring firm uses earnings losses of acquired to offset taxable gains 4. market positioning – enter new markets or increase markets by product or geography to enhance or continue growth 5. cost savings or efficiency, e.g., eliminate branch duplication and centralize operations such as data processing and credit cards 6. provide management succession for smaller banks 7. rescue of failing banks and thrifts See recent examples on pp. 624-625. Acquirer must usually pay a “merger premium” for stock of acquired (pp. 630-632), Do problems 1 & 2. Merger premium = New stock price / current stock price As premium increases, the number of new shares to the acquired increases and the total number of shares in the combined bank increases. As the number of shares increases, if we assume the combined earnings stay constant, then the EPS will decline which is referred to as earnings dilution. Increases in value must offset the dilution effect. Prices are also usually examined as price/book or price/earnings (AB, 8/14/07). Merger Accounting – Since 2001, purchase accounting has been used where the acquired firm is valued at the purchase price. Any excess purchase price over the value of the 1
  2. 2. assets of the acquired firm is added to the assets of the acquirer as goodwill (an intangible asset). The goodwill must not be amortized ( as before 2001) unless it is impaired. We saw the increase in goodwill back in the capital management chapter. Regulations related to U.S. bank mergers Bank Merger Act of 1960 - Requires each merging bank to request approval from its principal federal regulator. The two major factors are competitive effects of proposed merger and public benefits. Herfindahl-Hirschman Index (HHI) = sum of squared market shares See example on p. 636; range = near 0 for very unconcentrated markets to 10,000 or 1002 for a monopoly. A post-merger HHI of less than 1800 OR a change of less than 200 points would not likely be challenged by the U.S. Justice Department. Indexes above these levels would need to show increased public benefits from the proposed merger. Do Problem 3. Community Reinvestment Act (CRA) of 1977 - A bank with a low rating has an increased probability of having its proposed merger denied by the regulators. Merger Rules in Europe – The European Commission, an executive body of the European Union (EU), decides on mergers. It may deny a merger if the proposed combination would lead to collective dominance in a given market. An example of collective dominance is that the market would be so concentrated that only about four firms would dominate the market, e.g., HHI ≥ 2,500 or (4 X 252). What steps that management can take appear to contribute to the chances for success in a merger? There are several steps management can take to improve their chances of success after a merger. First they can know themselves, their strengths and weaknesses and the goals they want to pursue. They can also get a team together before any merger to do a detailed analysis of the potential merger and new market area. They can be careful to establish a realistic price for the target firm. Once the merger has taken place they should form a combined management team from both firms to direct the consolidation of the two firms. They should also establish lines of communication between senior management and branch and line management as well as communication channels for other employees and customers. Finally they should set up customer advisory panels to comment on the new bank’s community image, availability of services and helpfulness. Mergers sometimes produce disappointing results because of ill-prepared management, a mismatch of corporate cultures, excess prices paid by the acquirer, inattention to customers’ feelings and concerns and a general lack of fit between the two firms. Does it appear that most mergers among banking firms serve the public interest? Most studies that have looked at this issue find few real public benefits. Service charges and fees often rise following the completion of a merger; however, the menu of services offered to customers increases. There is no convincing evidence that the public has 2
  3. 3. suffered a decline in service quality or availability following most bank mergers. On the positive side, mergers may significantly lower the bank failure rate and reduce operating costs. Problems – p. 644 19-1. Evaluate the impact of the following proposed mergers upon post-merger earnings per share (EPS) of the combined organizations: a. The acquiring bank reports that the current a stock price is $20 per share and the bank earns $6 per share for its stockholders; the acquired bank’s stock is selling for $17 per share and that bank is earning $5 per share. The acquiring institution has issued 200,000 shares of common stock, whereas the acquired institution has 100,000 shares of stock outstanding. Stock will be exchanged in this merger transaction exactly at its current market price. Most recently, the acquiring bank turned in net earnings of $1,200,000 and the acquired banking firm reported net earnings of $300,000. Following this merger, combined earnings of $1,600,000 are expected. Answer: If earnings total $1,600,000 after the merger occurs, the acquired bank's shareholders will receive $17 / $20 or 0.85 of a share of stock in the acquiring bank for each share they held in the acquired institution. This means 0.85 x 100,000 or 85,000 additional shares of the acquiring bank will be issued for a post-merger total of 285,000 shares outstanding. Therefore, the post-merger EPS will be $1,600,000 / 285,000 shares or $5.61 per share. b. The financial firm to be acquired is currently earning $14 per share, and its acquirer is reporting earnings of $12 per share. The acquired firm’s stock is trading in today’s market at $27 per share, while the acquiring firm’s stock exchanges today for $24 per share. The acquired institution has 75,000 shares outstanding; the acquiring institution, on the other hand, has issued 80,000 shares of common stock. The combined organization is expected to earn $900,000; before the merger, the acquired bank posted net earnings of $400,000 and the acquiring bank tallied net earnings of $600,000. If the stock will be traded at the going market price to effect this merger, what will post-merger earnings per share be? Answer: Smith comment: The answer below is correct but this problem does not make any sense because the new organization will be earning a substantially lower EPS than either of the two merging firms. If the two banks agree to exchange stock at current market values, the acquired bank's stockholders will receive $27 / $24 or 1.125 shares in the acquiring bank for each share they hold or 84,375 (1.125 x 75,000) additional shares. After the merger there will be 164,375 shares outstanding. With $900,000 in post-merger earnings, the combined banking organization's EPS will be $900,000 / 164,375 shares or $5.475 per share. 3
  4. 4. 19-2. Under the following scenarios, calculate the merger premium and the exchange ratio: a. The acquired financial firm’s stock is selling in the market today at $10 per share, while the acquiring institution's stock is trading at $16. The acquiring firm’s stockholders have agreed to extend to shareholders of the target firm a bonus of $5. The acquired firm has 30,000 shares of common stock outstanding, and the acquiring institution has 50,000 common equity shares. Combined earnings after the merger are expected to remain at their pre-merger level of $1,250,000 (where the acquiring firm earned $1,000,000 and the acquired institution $250,000) A merger premium will be paid amounting to: Merger Premium (in Percent) = [($10 + $5) / $10] x 100 = 150 percent. With an additional $5 per-share bonus the acquired thrift's stock will be valued at $15, slightly lower than the acquiring institution's stock for a $15 / $16 or .9375:1 exchange ratio. Earnings per share from the merger will be: EPS = $1,250,000 / 78,125 shares = $16.00. Before the merger, the acquiring institution had an EPS of $20, while the acquired thrift reported an EPS of $8.33. This suggests there will be some earnings dilution for the shareholders of the acquiring institution. b. The acquiring financial service provider reports that its common stock is selling in today’s market at $25 per share. In contrast, the acquired institution’s equity shares are trading at $20 per share. To make the merger succeed, the acquired firm’s shareholders will be given a bonus of $1 per share. The acquiring institution has 120,000 shares of common stock issued and outstanding, while the acquired firm has issued 40,000 equity shares. The acquiring firm reported pre-merger annual earnings of $850,000, and the acquired institution earned $150,000. After the merger, earnings are expected to decline to $900,000. Is there any evidence of dilution of ownership or earnings in either merger transaction? If the acquiring bank's stock is currently selling for $25 per share and the acquired institution's shares are trading at $20 per share and the acquired firm's shareholders are offered a $1 per-share bonus to merge, the merger premium will be: Merger Premium (in Percent) = [($20 + $1) / $25] x 100 = 84 percent. 4
  5. 5. Thus, the acquired bank's stock will exchange in a ratio of $21 to $25 for the acquiring bank's stock or 0.84 to 1. Thus, the acquired bank's shareholders will receive 0.84 x 40,000 or 33,600 shares in the merged institution which will then have a total of 153,600 shares outstanding. Post-merger EPS should be: $900,000 / 153,600 shares = $ 5.86. Before the merger, the acquiring institution reported an EPS of $7.08 and the acquired institution had an EPS of $3.75. The acquiring institution's shareholders will experience some earnings dilution as well as some decline in their ownership share. 19-3. The Goldmore metropolitan area is presently served by five depository institutions with total deposits as follows (see table below). Calculate the Herfindahl- Hirschman Index (HHI) for the Goldmore metropolitan area. Suppose that Rocky Mountain Trust Company and Security National Bank propose to merge. What would happen to the HHI in the metropolitan area? Would the U.S. Department of Justice be likely to approve this proposed merger? Would your conclusion change if the Goldmore County Merchants Bank and the Rocky Mountain Trust Company planned to merge? The Herfindahl-Hirschman Index for the Goldmore Metropolitan Area is calculated as follows: Bank Current Deposits Current Deposit Current Deposit Market Share Market Share Squared Goldmore National Bank $ 840 million 39.22 % 1538.21 Goldmore County $600 million 28.01% 784.56 Merchants Bank Commerce National Bank 395 million 18.44% 340.03 Rocky Mountain Trust 200 million 9.34% 87.24 Company Security National Bank 107 million 5.00% 25.00 Total $2142 million 100.0 % 2775.04 The Goldmore market has an HHI above 1800 and is, therefore, highly concentrated. If Rocky Mountain Trust Co. and Security National Bank merge, their combined market share is 14.34 percent and the HHI climbs to 2868.44, a change of only 93.4 points which may be acceptable to the regulatory authorities. However, if Goldmore County Merchants Bank and Rocky Mountain Trust Company plan to merge, the combined market share of these two banks is 37.35 percent and the HHI rises to 3298.26, a change of 523.22 points which will, in all probability, be challenged by the regulatory authorities. _____________________________________________________________ 5
  6. 6. Another merger example To determine the amount of the offer for the target firm the acquiring firm must evaluate the impact on the wealth of the current stockholders. What is today’s value (# shares X EPS X PE)? If a premium is offered to the target then management must show the current stockholders how they will recover the premium that is being paid. What will the new company look like? See the simple Excel example to see how characteristics of the merger can be evaluated 6