Lecture 7: Mergers and

Acquisitions (M&A’s)
 Terminology

• A merger is a reorganisation of assets between two

equal-sized companies who agree to join together. True
mergers are comparatively rare.
• A takeover (acquisition) is the buying of the share
capital of one company by another.
• Acquisitions are quite common and may be friendly or
unfriendly in nature.
 Terminology (Continued)

Horizontal Acquisition:
• Companies in the same industry and stage of production.
• Most common acquisition and most likely to succeed.
• Also, the most likely kind of acquisition to be referred to the
government authority regulating Competition.
• Example: in UK Morrison’s acquisition of Safeway in 2003
after a long Competition Commission investigation.
 Terminology (Continued)

Vertical Acquisition:
• Companies in the same industry at different stages of
production.
• Either backwards towards suppliers or forwards towards
distribution.

• Secures vital outlets for finished products or necessary

sources of raw materials.
 Terminology (Continued)

Conglomerate Acquisition:
• Companies in different industries
• Least likely to be successful
 Justifications for acquisition
1. Economic Justifications:
• If market value of new firm exceeds separate market values,
shareholder wealth increases
PVX+Y > (PVX + PVY)
• Economic motives seek to raise cash flows by increasing
revenue or decreasing costs.
• Economic gains may be generated for a number of reasons:

i. Synergy:
• occurs when the assets and/or operations of two companies
complement each other, so that their combined output is more than the
sum of their separate outputs
• arise when complementary activities lead to increasing profit or output.
(synergy= PVX+Y - (PVX + PVY))
 Justifications for acquisition
(Continued)
2. Economic Justifications:
ii. Economies of scale:
• Larger scale of operations or more efficient use of assets
following an acquisition leads to a decrease in average unit
cost.
• Economies of scale can occur in production, distribution,
marketing and so on.
• Economies of scale may be seen as an
operating synergy.
Justifications for acquisition (Continued)

2. Economic Justifications:
iii. Economies of vertical integration:
• Coordinate operations more effectively
• Reduced search cost for suppliers or customers
 Justifications for acquisition
(Continued)
2. Economic Justifications:
iv. Elimination of inefficient management:
• If company is poorly run, its share price will fall and it
becomes a target for acquisition.
• Increased output or revenue and lower costs can arise from
transfer of managerial skills or elimination of inefficient
managers.
• Managerial skills of acquirer complement assets of target
firm, hence higher profits.
 Justifications for acquisition
(Continued)
2. Economic Justifications:
v. Market-related factors:
• New market entry for existing products,
•e.g. acquisition faster than organic growth
• Critical mass achieved,
•e.g. minimum size to effectively carry costs such as R+D
• Growth of market share
• Increased market power or market share
 Justifications for acquisition
(Continued)
2. Financial justifications:
i. Financial synergy:
• This refers to decrease in cost of capital through acquisition.
• Increased size can lead to financing scale economies, e.g. lower issue
costs.
• Increased size can yield lower interest rates and lower cost of debt
due to lower risk.
• Decreased cash flow volatility can also decrease risk and lower cost
of capital.
 Justifications for acquisition
(Continued)
2. Financial justifications:
ii. Target undervaluation:
• Some target companies may be bargain buys
 Justifications for acquisition
(Continued)
2. Financial justifications:
iii. Earnings growth? (real benefit only if there is synergy)
• Acquisition may create the appearance of growth in earnings
per share
• If there are no synergies or other benefits to the acquisition,
then the growth in EPS is just an artifact of a larger firm and is
not true growth.
• In this case, the P/E ratio should fall because the combined
market value should not change
• There is no free lunch!
Justifications for acquisition (Continued)

2. Financial justifications
iv. Tax Considerations
• Take advantage of net operating losses: acquisition can bring losses and profits together.
Taxes drop if after acquisition losses in one firm offsets the gain in the other.
• Increase debt capacity (benefiting from bigger tax shield)
• Surplus funds: free cash flow can be used for acquisition avoiding taxes for shareholders
of the acquiring firm (taxes they would have paid on dividend)
 Justifications for acquisition
(Continued)
3. Managerial motives:
• Agency problem can manifest through acquisitions.
• Motive for acquisitions may be power, remuneration, perks,
job security (for managers).
• Managerial motives can lead to decrease in shareholder
wealth.
• Acquiring shareholders rarely benefit.
 Against acquisition
• The need of approval by government regulator:
• Possible damages to wealth of acquirer
• Formal investigation means long costly delay
• Acquisition may be blocked or amended
• Bid is contested:
• Large acquisition premium if bid contested
• Premium up to 50% not uncommon
 Against acquisition (Continued)

Cost of financing acquisition:

• Share-for-share offer:
• Acquirer must pay dividends on new shares
• Ownership and control changes
• Cash offer (financed by debt):
• Gearing levels may increase sharply
• Interest payments may be hard to meet
• Acquisition transaction cost to be met
 Against acquisition (Continued)

Other difficulties:
• Cultural problems
• Exchange rate risk (cross-border mergers)
• Complex taxation and legal issues
• Quality of assets purchased may be uncertain
Against acquisition (Continued)

Are acquisitions beneficial anyway?

• Research shows that benefits arising from synergy and economies of
scale rarely happen.
• In general, the only beneficiaries from takeovers are the target
company’s shareholders and the bidding company’s management.
 Merger and Acquisitions waves
(Continued)
Merger and acquisitions tend to occur in waves:
Possible explanations:
• booming stock exchange (enabling companies to use
shares to finance acquisitions)
• an increase in companies’ real liquidity and profitability
levels is often cited as a factor encouraging takeover
activity.
• deregulation of financial system and markets;
• globalisation of markets;
• changes in antitrust (competition) legislation.
 Financing the acquisition: cash
offers
Attractive to target company’s shareholders because:
• Compensation they receive for their shares is certain in
value.
• They adjust their portfolios to suit.

Disadvantage:
• Sellers may be liable to pay capital gains tax on shares
sold to bidder.
 Financing the acquisition: cash
offers(Continued)
Advantages to bidding company:
• Can see exactly how much is being offered.
• No effect on number of issued shares.
• will not alter its ownership structure nor lead to a dilution of its
earnings per share.

A major issue is where the cash comes from:

• Cash from retained earnings is usually insufficient to buy target
company shares.
• Pre-bid bond issue or bank loans could be used, but gearing and
interest rate changes must be considered.
 The NPV of an Acquisition:
1. Cash Acquisition
 The NPV of a cash acquisition is
NPV = VB* – cash cost
 Value of the combined firm is
VAB = VA + (VB* - cash cost)
 NPV to acquirer = synergy – premium

26-25
Financing Acquisition – share-for-share
offers
• Target company shareholders are offered a fixed number of shares
in the bidder in exchange for their shares.

Advantages for target company shareholders:

• Retain equity interest in their company.
• No brokerage costs from reinvesting cash and no capital gains tax
liability.
Financing – share-for-share offers
(Continued)
Disadvantages to acquiring company and its shareholders:
• More expensive than cash offers as share for share offer should be
generous to protect against fall in market price of bidding company’s
shares during the offer period.
• Increases number of shares in circulation.
• Share issue may move bidder away from its optimal capital structure.
 The NPV of an Acquisition:
2. Stock Acquisition
 Value of combined firm:
VAB = VA + VB + V
 Cost of acquisition
 Depends on the number of shares given to the target
stockholders.
 Depends on the price of the combined firm’s stock after the
acquisition.
 Note:
 The number of shares given to target stockholders determines
whether the cost of using stocks to acquire the target firm is higher
than using cash.
 How many shares should be used in order for the transaction using
stock acquisition is worth exactly the cash-for-stock transaction?
 𝜶 = New shares issued/Old shares(owned by the acquirer)+ new shares issues
 Stock vs. Cash Acquisition
Considerations when choosing between
cash and stock:
 Sharing gains – target stockholders don’t
participate in stock price appreciation
with a cash acquisition
 Taxes – cash acquisitions are generally
taxable
 Control – cash acquisitions do not dilute
control
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 Strategic and practical issues

Strategic process of acquiring target company:

• Identify suitable target companies (synergy is crucial)
• Obtain information on these targets
• Value each target company and decide on the maximum
purchase price
• Choose most appropriate potential target
• Identify best way to finance the acquisition
• Select tactics likely to make bid successful
 Bid defences: Defensive tactics

• Decision to contest a bid should be made in the best interests of

the shareholders.
• Constructive pre-bid defences:
 Improving operational efficiency
 Examining asset portfolios and making necessary divestments
 Ensuring good investor relations
 Bid defences (Continued)
Obstructive pre-bid defences:
• Restructuring of equity:
 Share repurchase schemes (greenmail)
 Increase their gearing level in order to make themselves less
attractive.
 Poison pills
• Management retrenchment devices:
 Golden parachutes
• Strategic defence via cross-holdings
 Bid defences (Continued)
Post-bid defences:
• Rejection of the initial offer
• A pre-emptive circulation to shareholders
• Formulation of a defence document
• Profits announcements and forecasts
• Dividend increase announcements
• Revaluation of assets
• Searching for a white knight
• Pac-man defence
• Acquisitions and divestments (Crown jewel defence)
 Divestment (Divestiture)

Reasons for divestment:

• To raise cash to ease liquidity problem
• To raise cash to reduce gearing
• To allow firms to focus on core activities and perhaps generate
economies of scale
• Divested assets may be worth more in the hands of specialist
managers
• Crown jewel defence
 Divestment strategies
Sell-off:
• Company sells off part of its operations to a third party, usually for cash
Spin-off or demerger:
 A parent firm turns a division into a separate entity
 Pro rata distribution of subsidiary shares (for free) to parent shareholders
 Structure of firm changes, but no assets are sold and control remains with parent
 Increase corporate focus
Carve-out
 Firm turns a division into a separate entity and then sells shares in the division to the public.
 Generally the parent retains a large interest in the division.
Management buyout
 the purchase of part or all of a business from its parent company by the existing management of the
business
 E.g. the purchase of a subsidiary company from the parent by the subsidiary’s management.
 if the subsidiary is loss-making, the current management may be more optimistic that they can turn the situation
round than an outside buyer may be.
 Good solution in a situation where managers of subsidiary feel marginalized by parent company from the
decision making process.
 Empirical research (Continued)

The shareholders:
• Accounting studies indicate that acquisitions are unprofitable to the
acquirer.
• Event studies (before and after comparisons) show that target
company shareholders get significant gains while acquiring company
shareholders get no gains or even a loss.
• Bidders may earn gains prior to the bid.
 Empirical research (Continued)

The shareholders:
• Gain of target company shareholders’ is likely to be a result of bid
premium.
• Acquiring company shareholders’ lack of gain may be due to
anticipation of acquisition by efficient market.
• Many surveys conclude that acquisitions transfer rather than create
wealth.
 Empirical research (Continued)

Managers and employees:

• Acquiring company managers benefit from:
 increased power and status;
 increased financial rewards;
 increased job security.
• Managers of target companies tend to lose their jobs following an
acquisition, while their employees also face uncertain futures.
 Empirical research (Continued)

• The winners:
 Acquiring company managers, financial institutions and target company shareholders
• Neutral effect:
 The economy
• The losers:
 Acquiring company shareholders, target company managers and employees