Mergers and Acquisitions Basic Forms of Acquisitions There

Mergers and Acquisitions

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

MERGER Ø One firm is acquired by another firm Ø Acquiring firm (i) retains its name & identity and (ii) acquires all Assets & Liabilities of the acquired firm Ø Acquired firm ceases to exist

Consolidation Ø Entirely new firm is created from combination of existing firms. Ø Acquiring and acquired firm terminate their previous legal existence & becomes part of the new firm

Acquisition of Stock Ø A firm can be acquired by another firm through purchase of voting shares of the firm’s stock Ø Tender offer – public offer to buy shares of a target firm Ø Factors affecting Stock acquisition – No stockholder vote required – Can deal directly with stockholders, even if management is unfriendly – May be delayed if some target shareholders hold out for more money

Classifications ØHorizontal – both firms(acquirer & acquired) are in the same industry ØVertical – firms are in different stages of the production process ØConglomerate – firms are unrelated

TAKEOVERS Ø Transfer of control* of a firm from one group of shareholders to another * Control- majority vote on the Board of Directors Ø Bidder & Target firm Bidder firm- offers to pay cash or securities to obtain stock of assets of another company Target firm- will give up control over its assets or stock in exchange for consideration

Varieties of Takeovers Merger Takeovers Acquisition of Stock Proxy Contest Acquisition of Assets Going Private (LBO)

Proxy Contest Ø Group of shareholders attempt to gain seat on the Board of Directors Ø Written authorization for one shareholder to vote the stock for another

Going Private Transactions Ø Small group of investors purchases ALL EQUITY SHARES of a public firm. Ø Shares of the firm are delisted from stock exchanges & no longer can be purchased in the open market

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

Sources of Synergy • Revenue Enhancement • Cost Reduction – Replacement of ineffective managers – Economy of scale or scope • Tax Gains – Net operating losses – Unused debt capacity • Incremental new investment required in working capital and fixed assets

Revenue Enhancement Ø Marketing gains Ø Strategic benefits Ø Market power

Cost Reduction Ø Economy of scale or scope Ø Technology transfer(GM & Hughes Aircraft) Ø Replacement of ineffective managers

Tax Gains ØNet operating losses ØUnused debt capacity

Calculating Value in case of Mergers and Acquisitions Ø Points to be remembered: 1. Do not ignore market values 2. Estimate only Incremental cash flows 3. Use the correct discount rate 4. Do not forget transactions costs

Cash Acquisition Ø The NPV of a cash acquisition is: NPV = (VB + ΔV) – cash cost = VB* – cash cost Ø Value of the combined firm is: VAB = VA + (VB* – cash cost) Ø Often, the entire NPV goes to the target firm.

Stock Acquisition Firm A is acquiring firm and Firm B is a target firm , then: 1. Value of combined firm VAB = Value of firm A + Value of firm B + Synergical benefits(in terms of NPV) 2. Cost of acquisition = Merger Price* – Value of firm B *(No. of shares offered by firm A to firm B X market price per share of firm A) 3. NPV = Synergical benefits - Costs of acquisition (in terms of NPV)

Q. XYZ Inc. plans to acquire ABC Corporation for which the following information has been provided: Particulars XYZ Inc. ABC Corp. Market price / share Rs. 150 Rs. 60 No. of shares 1, 000 500 Market value Rs. 1, 50, 000 Rs. 30, 000 The merger of two firms is expected to bring benefits of which the NPV is estimated at Rs. 30, 000. XYZ Inc. offers 250 shares to the shareholders of ABC Corp. for merger proposal. Required: NPV of the merger decision and Value of merged firm?

Ans. NPV = Synergical benefits (NPV terms) – *Cost of acquisition = Rs. 30, 000 – Rs. 7, 500 = Rs. 22, 500 Value of merged firm = Value of XYZ Inc. + Value of ABC Corp. + synergical benefits = Rs. 1, 50, 000+ Rs. 30, 000 = Rs. 2, 10, 000 *Cost = Merger Price** – Value of ABC Corp. = Rs. 37, 500 – Rs. 30, 000 = Rs. 7, 500 **Merger Price = 250 shares x Rs. 150 = Rs. 37, 500

Q. Firm A is planning to acquire Firm B by way of merger. The following data is available as under: Particulars Firm A Firm B Earnings after tax Rs. 2, 000 Rs. 60, 000 No. of equity shares 40, 000 10, 000 Market value/share Rs. 15 Rs. 12 (i) If the merger goes through by exchange of equity share & the exchange ratio is based on the current market price, what is the new earnings per share for Firm A? (ii) Firm B wants to be sure that the earnings available to the shareholders will not be diminished by the merger. What should be the exchange ratio in this case?

Ans. (i) New EPS for Firm A= Rs. 2, 60, 000 = Rs. 5. 42 48, 000* Firm B will get 8, 000 shares (Rs. 12/Rs. 15 x 10, 000) *Total no. of shares = 40, 000 + 8, 000= 48, 000 (ii) Calculation of exchange ratio to maintain earnings: Present EPS of two firms Firm A = Rs. 2, 000/40, 000 = Rs. 5 Firm B = Rs. 60, 000/10, 000 = Rs. 6 Exchange ratio= 6/5, i. e. 1. 20 No. of new shares= 10, 000 x 1. 20= 12, 000 EPS after merger = Rs. 2, 60, 000/(40, 000+12, 000) = Rs. 5

Friendly vs. Hostile Takeovers • In a friendly merger, both companies’ management are receptive. • In a hostile merger, the acquiring firm attempts to gain control of the target without their approval. • Tender offer • Proxy fight

Defensive Tactics • • • Golden parachutes Targeted repurchase Standstill agreements Poison pills (share rights plans) Leveraged buyouts

Accounting for Acquisitions Ø The Purchase Method q Assets of the acquired firm are reported at their fair market value. q Any excess payment above the fair market value is reported as “goodwill. ” q Earlier, goodwill on acquisition was amortized. Now it remains on the books of accounts until it is deemed “impaired. ”

Going Private and Leveraged Buyouts ü The existing management buys the firm from the shareholders and takes it private. ü If it is financed with a lot of debt, it is a leveraged buyout (LBO). ü The extra debt provides a tax deduction for the new owners, while at the same time turning the pervious managers into owners.