Corporate Finance

1. Corporate Finance Class 11 Mergers and Acquisitions Daniel Sungyeon Kim Peking University HSBC Business School

2. The Basic Forms of Acquisitions • There are three basic legal procedures that one firm can use to acquire another firm: • Merger or Consolidation • Acquisition of Stock • Acquisition of Assets

3. Merger versus Consolidation • Merger • One firm is acquired by another • Acquiring firm retains name and acquired firm ceases to exist • Advantage – legally simple • Disadvantage – must be approved by stockholders of both firms • Recent examples • Washington Mutual was merged with JPMorgan Chase on September 25, 2008 • Northwest Airlines was merged with Delta Airlines on October 29, 2008 • AirTran was merged with Southwest airlines on September 27, 2010.

4. Merger versus Consolidation • Consolidation • Entirely new firm is created from combination of existing firms • Both the acquiring firm and the acquired firm terminate their legal existence and become part of the new company. • Two Examples • JPMorgan and Chase were consolidated in 2000 and JPMorgan Chase was created. • AOL and Time Warner was consolidated in 2001 and AOL Time Warner was created. (On May 28, 2009, Time Warner announced that it would spin off AOL on December 9, 2009).

5. Acquisition of Stock • A firm can acquire another firm through purchasing voting shares of the firm’s stock • Tender offer – public offer to buy shares • Stock acquisition • No stockholder vote required • Can deal directly with stockholders, even if management is unfriendly • Classifications • Horizontal – both firms are in the same industry • Vertical – firms are in different stages of the production process • Conglomerate – firms are unrelated

6. Acquisition of Assets • A firm can be acquired by another through selling all of its assets. • The acquired firm may not vanish since its “shell” may be retained. • A formal vote of the target shareholders is needed.

7. Synergy • The most important motivation for acquisitions is that synergy could be created. • Most acquisitions actually fail to create value for the acquirer. • Synergy is the source of benefit to stockholders. • …but more than 50% of acquisitions do not create synergy.

8. S T DCFt Synergy = (1 + r)t t = 1 Synergy • Suppose firm A is considering acquiring firm B. • The synergy from the acquisition is Synergy = VAB – (VA + VB) • The synergy of an acquisition can be determined from the standard discounted cash flow model: where

9. Sources of Synergy • Revenue Enhancement • Marketing Gains • Market or Monopoly Power • Cost Reduction • Replacement of ineffective managers • Economy of scale or scope • Tax Gains • Net operating losses • Unused debt capacity • Reduced capital requirements • Duplicate facilities

10. How Is the Synergy Shared? • Seller’s Gain=Premium = PB - VB. • PB is the price paid for the target firm. • Acquirer’s Gain = Synergy – Premium • Acquirer’s Gain + Seller’s Gain = Synergy • Example: if the stock of the target is selling for $50/share, the acquirer decides to pay $60/ share. Suppose the synergy from the merger is $30/share, then the premium is $10/share, and the acquirer’s gain is $20/share.

11. An Exercise • GLD Corp. is investigating the possible acquisition of Stopper Systems Inc. The following data are available: • The cost of equity of both firms is 15%. The merged firm is expected to grow at 5% per year without additional capital investments. GLD plans to offer 14.7 million cash to buy Stopper Systems’ entire stock. • What is the value of the merged company? • What are the gains (losses) to each group of shareholders? • What is the synergy value created from the merge?

12. Calculating Value • Avoiding Mistakes • Always use market values • Estimate only incremental cash flows • Use the correct discount rate • Do not forget transactions costs

13. Two “Bad” Reasons for Mergers • Earnings Growth • If there are no synergies or other benefits to the merger, then the growth in EPS is just an artifact of a larger firm and is not true growth (i.e., an accounting illusion).

14. Two “Bad” Reasons for Mergers • Diversification • A firm’s risk can be separated into two parts • Systematic risk: cannot be diversified away • Unsystematic risk: can, but… • Shareholders who wish to diversify can accomplish this at much lower cost with one phone call to their broker than can management with a takeover. • There is a diversification discount of 13%-15% for diversified firms.

15. A cost to stockholders: Overview • Mergers may raise the value of bondholders but hurt shareholders’ value. • Bondholders gain from the merger because their debt is now “insured” by two firms, not just one. • The gain to the bondholders is at the stockholders’ expense. • It is a zero-sum game.

16. A Cost to Stockholders • The Base Case • If two all-equity firms merge, the stockholders of both firms are indifferent to the merger.

17. A Cost to Stockholders • Both Firms Have Debt • The value of shareholders falls while that of bonderholders rises. • Suppose firm A has $30 debt and firm B has $15 debt

18. A Cost to Stockholders • After merger, the bondhoders gain and the shareholders lose. Why? • Coinsrance effect • Before merger, if one firm defaults on its debt, the other firm does not need to help the bondholders of the firm. • After merger, when one of the divisions of the combined firm fails, creditors can be paid from the profits of the other division. • The merger shifts the value from shareholders to bondholders. • Note this is a so-called zero-sum game: no total value created, but stockholders are hurt by the exactly same amount that bondholders gain.

19. An exercise • The shareholders of Firm A have voted in favor of a buyout offer from firm B. Information about each firm is given below. Firm A’s shareholders will receive one share of firm B stock for every three shares they hold in firm A • The NPV of the acquisition is zero. What will the EPS of Firm B be after the merger? What will the PE ratio of Firm B be? • What is the cost of the acquisition if the NPV of the acquisition is zero?

20. The NPV of a Merger • Typically, a firm would use NPV analysis when making acquisitions. • The analysis is straightforward with a cash offer, but gets complicated when the consideration is stock.

21. Cash Acquisition • The NPV of a cash acquisition is: • NPV = (VB + Synergy) – cash cost • Where firm B is the target • NPV of a merger to acquirer=Synergy-Premium • In realty, the entire NPV often goes to the target firm.

22. An example • Consider the following pre-merger information about a bidding firm (firm A) and a target firm (firm B). Assume that both firms have no debt outstanding and the synergy is estimated to be $3,000. • If firm B is willing to be acquired for $27 per share in cash, what is the NPV of the merger? • What will the price per share of the merged firm be? • What is the merger premium?

23. Stock Acquisition • Value of combined firm • VAB = VA + VB + V • Cost of acquisition is not straightforward like cash acquisition. • Depends on the number of shares given to the target stockholders • Depends on the price of the combined firm’s stock after the merger

24. An example (cont’d) • Consider the following pre-merger information about a bidding firm (firm A) and a target firm (firm B). Assume that both firms have no debt outstanding and the synergy is estimated to be $3,000. • If firm B is agreeable to a merge by an exchange of stock and A offers three of its shares for every five of B’s shares. What will the price per share of the merged firm be? • What is the cost of acquisition for firm A? • What is the NPV of the merger?

25. Cash Vs. Stock • Sharing gains – target stockholders do not participate in stock price appreciation with a cash acquisition • Control – cash acquisitions do not dilute control • Information asymmetry: • Bidders want to use stock-acquisition if their stocks are overvalued and cash–acquisition if their stocks are undervalued. • Targets are not fool, i.e., they expect bidders’ stocks are overpriced if stock-for-stock deal is offered and they want to push for better terms. • Market learns also: empirical evidence shows that bidder’s CAR is negative upon the announcement of a stock-for-stock deal and positive upon the announcement of cash acquisition.

26. An example (cont’d) • Consider the following premerger information about a bidding firm (firm A) and a target firm (firm B). Assume that both firms have no debt outstanding and the synergy is estimated to be $3,000. • Are the shareholders of firm B better off with the cash offer or the stock offer?

27. An example (cont’d) • Consider the following premerger information about a bidding firm (firm A) and a target firm (firm B). Assume that both firms have no debt outstanding and the synergy is estimated to be $3,000. • If firm B is agreeable to a merge by a combination offer: (1) $3 per share in cash and (2) an exchange of stock that A offers three of its shares for every five of B’s shares. What will the price per share of the merged firm be? • What is the cost of acquisition for firm A? • What is the NPV of the merger?

28. Friendly vs. Hostile Takeovers • In a friendly merger, both companies’ management are receptive. • The merger is initiated by the acquiring firm. • Two firms are sitting down and negotiating for terms of the deal. • Boards give the approval and shareholders vote. • In a hostile merger, the acquiring firm attempts to gain control of the target without their approval. • Tender offer: an offer made directly to the stockholders to buy shares at a premium above the current market price. • Toehold: the acquirer purchases some of the target’s stock in secret before the formal announcement. • Proxy fight: after purchasing shares in the target, the acquirer nominates a slate of candidates to run against the current directors. If the acquirer’s candidates win a majority of seats on the board, the acquirer will control the firm.

29. Defensive Tactics • Key idea: deter takeovers by raising the cost of acquisition. • Corporate charter • Classified board (i.e., staggered elections) • Supermajority voting requirement • Golden Parachutes • Greenmail • Standstill agreements • Poison pills (share rights plans) • Asset Restructurings • Dual-class stock structure

30. More (Colorful) Terms • Poison put • Crown jewel • White knight • Lockup • Shark repellent • Bear hug • Fair price provision • Countertender offer

31. Do Mergers Add Value? • Shareholders of target companies tend to earn excess returns in a merger: • Target firm managers have a tendency to oppose mergers, thus driving up the tender price.

32. Going Private and Leveraged Buyouts • The existing management buys the firm from the shareholders and takes it private. • If it is financed with a lot of debt, it is a leveraged buyout (LBO). • The extra debt provides a tax deduction for the new owners, while at the same time turning the pervious managers into owners. • This reduces the agency costs of equity because managers have to pay out free cash for interest rather than waste it.

33. An Exercise • Firm A is analyzing the possible acquisition of firm B. Neither firm has debt. The forecast of firm A show that the purchases would increase its annual after-tax cash flow by $600,000 indefinitely. The current market value of firm B is $20 million, the current market value of firm A is $35 million. The appropriate discount rate for the incremental cash flows is 8%. Firm A is trying to decide if it would offer 25% of its stock or $25 million in cash to firm B • What is the synergy from the merger? • What is the value of firm B to firm A? • What is the cost to firm A of each alternative? • What is the NPV to firm A of each alternative? • What alternative should firm A use?

34. Key Points • Forms of acquisitions • Merger or Consolidation • Acquisition of Stock • Acquisition of Assets • Synergy • Source of synergy • Sharing of synergy • Coinsurance effect of mergers • Payment Method • Cash offer • Stock offer • Friendly versus Hostile Acquisition • Empirical Evidence • LBOs