1. business and industrial
2. company
3. merger and acquisition

CHAPTER 10
MERGERS AND ACQUISITIONS
Presenter’s name
Presenter’s title
dd Month yyyy
1. INTRODUCTION
• Mergers and acquisitions (M&A) are complex, involving many parties.
• Mergers and acquisitions involve many issues, including
- Corporate governance.
- Form of payment.
- Legal issues.
- Contractual issues.
- Regulatory approval.
• M&A analysis requires the application of valuation tools to evaluate the M&A
decision.
Copyright © 2013 CFA Institute
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EXAMPLE OF A MERGER:
AMR AND U.S. AIRWAYS
November
2012
July 2012
• U.S.
Airways
proposes
merger to
bankrupt
AMR.
April 2012
• AMR creditors
encourage AMR
to merge with
another airline,
instead of
emerging from
bankruptcy alone.
• AMR and
U.S. Airways
begin
merger
discussions.
September
2012
• U.S. Airways proposes
merger, with its
shareholders owning
30% of the new
company.
• Details of the
merger are
worked out.
• Merger filed
with the FTC
under HartScott-Rodino
Act.
February
2013
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2. MERGERS AND ACQUISITIONS DEFINITIONS
Merger with Consolidation
Company
A
Acquisition
Company
X
Company
C
Company
B
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Company
X
Company
Y
4
MERGERS AND ACQUISITIONS DEFINITIONS
• Parties to the acquisitions:
- The target company (or target) is the company being acquired.
- The acquiring company (or acquirer) is the company acquiring the target.
• Classified based on endorsement of parties’ management:
- A hostile takeover is when the target company board of directors objects to
a takeover offer.
- A friendly transaction is when the target company board of directors
endorses the merger or acquisition offer.
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MERGERS AND ACQUISITIONS DEFINITIONS
Classified by the relatedness of business activities of the parties to the
combination:
Type
Characteristic
Example
Horizontal
merger
Companies are in the
same line of business,
often competitors.
Walt Disney Company
buys Lucasfilm (October
2012).
Vertical merger
Companies are in the
same line of production
(e.g., supplier–customer).
Google acquired Motorola
Mobility Holdings (June
2012).
Conglomerate
merger
Companies are in
unrelated lines of
business.
Berkshire Hathaway
acquires Lubrizol (2011).
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3. MOTIVES FOR MERGER
Creating Value
•
•
•
•
•
Synergy
Growth
Increasing market power
Acquiring unique capabilities or resources
Unlocking hidden value
Cross-Border
Mergers
•
•
•
•
•
Exploiting market imperfections
Overcoming adverse government policy
Technology transfer
Product differentiation
Following clients
Dubious
Motives
•
•
•
•
Diversification
Bootstrapping earnings
Managers’ personal incentives
Tax considerations
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EXAMPLE: BOOTSTRAPPING EARNINGS
Bootstrapping earnings is the increase in earnings per share as a result of
a merger, combined with the market’s use of the pre-merger P/E to value
post-merger EPS.
Assumptions:
• Exchange ratio: One share of Company One for two shares of Company Two
• Market applies pre-merger P/E of Company One to post-merger earnings.
Company Two
Company One
Post-Acquisition
$100 million
$50 million
$150 million
100 million
50 million
125 million
Earnings per share
$1
$1
$1.20
P/E
20
10
20
$20
$10
$24
$2,000 million
$500 million
$3,000 million
Company One
Earnings
Number of shares
Price per share
Market value of stock
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EXAMPLE: BOOTSTRAPPING EARNINGS
Weighted P E =
$100
× 20 +
$150
$50
× 10 = 16.67
$150
Assumptions:
• Exchange ratio: One share of Company One for two shares of Company Two
• Market applies weighted average P/E to the post-merger company.
Company Two
Company One
Post-Acquisition
$100 million
$50 million
$150 million
100 million
50 million
125 million
Earnings per share
$1
$1
$1.20
P/E
20
10
16.67
$20
$10
$20
$2,000 million
$500 million
$2,500 million
Company One
Earnings
Number of shares
Price per share
Market value of stock
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MOTIVES AND THE INDUSTRY’S LIFE CYCLE
• The motives for a merger are influenced, in part, by the industry’s stage in its
life cycle.
• Factors include
- Need for capital.
- Need for resources.
- Degree of competition and the number of competitors.
- Growth opportunities (organic vs. external).
- Opportunities for synergy.
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MERGERS AND THE INDUSTRY LIFE CYCLE
Industry Life
Industry
Cycle Stage
Description
Motives for Merger
Pioneering
 Industry exhibits
 Younger, smaller companies may
development
substantial
sell themselves to larger companies
development costs in mature or declining industries
and has low, but
and look for ways to enter into a
slowly increasing,
new growth industry.
sales growth.
 Young companies may look to
merge with companies that allow
them to pool management and
capital resources.
Rapid
 Industry exhibits
 Explosive growth in sales may
accelerating
high profit margins require large capital requirements
growth
to expand existing capacity.
caused by few
participants in the
market.
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Types of
Mergers
 Conglomerate
 Horizontal
 Conglomerate
 Horizontal
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MERGERS AND THE INDUSTRY LIFE CYCLE
Industry Life
Industry
Cycle Stage
Description
Mature
 Industry
growth
experiences a
drop in the entry
of new
competitors, but
growth potential
remains.
Stabilization  Industry faces
and market
increasing
maturity
competition and
capacity
constraints.
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Motives for Merger
 Mergers may be undertaken to
achieve economies of scale,
savings, and operational
efficiencies.
Types of
Mergers
 Horizontal
 Vertical
 Horizontal
 Mergers may be undertaken to
achieve economies of scale in
research, production, and
marketing to match the low cost
and price performance of other
companies (domestic and foreign).
 Large companies may acquire
smaller companies to improve
management and provide a broader
financial base.
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MERGERS AND THE INDUSTRY LIFE CYCLE
Industry Life
Industry
Cycle Stage
Description
Deceleration  Industry faces
of growth and overcapacity and
decline
eroding profit
margins.




Copyright © 2013 CFA Institute
Types of
Motives for Merger
Mergers
Horizontal mergers may be
 Horizontal
undertaken to ensure survival.
 Vertical
Vertical mergers may be carried out  Conglomerate
to increase efficiency and profit
margins.
Companies in related industries
may merge to exploit synergy.
Companies in this industry may
acquire companies in young
industries.
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4. TRANSACTION CHARACTERISTICS
Form of the
Transaction
Method of
Payment
Attitude of
Management
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• Stock purchase
• Asset purchase
• Cash
• Securities
• Combination of cash and securities
• Hostile
• Friendly
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FORM OF AN ACQUISITION
• In a stock purchase, the acquirer provides cash, stock, or combination of
cash and stock in exchange for the stock of the target firm.
- A stock purchase needs shareholder approval.
- Target shareholders are taxed on any gain.
- Acquirer assumes target’s liabilities.
• In an asset purchase, the acquirer buys the assets of the target firm, paying
the target firm directly.
- An asset purchase may not need shareholder approval.
- Acquirer likely avoids assumption of liabilities.
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METHOD OF PAYMENT
• Cash offering
- Cash offering may be cash from
existing acquirer balances or from a
debt issue.
• Securities offering
- Target shareholders receive shares
of common stock, preferred stock, or
debt of the acquirer.
- The exchange ratio determines the
number of securities received in
exchange for a share of target stock.
• Factors influencing method of
payment:
- Sharing of risk among the acquirer
and target shareholders.
- Signaling by the acquiring firm.
- Capital structure of the acquiring
firm.
Copyright © 2013 CFA Institute
Merger Transactions, 2005
Cash only
Stock only
Cash and
securities
Other
securities
Based on data from Mergerstat Review, 2006. FactSet
Mergerstat, LLC (www.mergerstat.com).
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MINDSET OF MANAGERS
Friendly merger: Offer made through
the target’s board of directors
Approach target management.
Enter into merger discussions.
Hostile merger: Offer made directly
to the target shareholders
Types
• Bear hug
• Tender offer
• Proxy fight
Perform due diligence.
Enter into a definitive merger agreement.
Shareholders and regulators approve.
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HOSTILE VS. FRIENDLY MERGERS
• The classification of a merger as friendly or hostile is from the perspective of
the board of directors of the target company.
• A friendly merger is one in which the board negotiates and accepts an offer.
• A hostile merger is one in which the board of the target firm attempts to
prevent the merger offer from being successful.
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5. TAKEOVERS
Takeover defenses are intended to either prevent the transaction from taking
place or to increase the offer.
- Pre-offer mechanisms are triggered by changes in control, generally making
the target less attractive.
- Post-offer mechanisms tend to address ownership of shares and reduce the
hostile acquirer’s power gained from its ownership interest in the target.
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TAKEOVER DEFENSES
Pre-Offer Takeover Defense
Mechanisms
Post-Offer Takeover Defense
Mechanisms
• Poison pills (flip-in pill and flip-over
pill)
• “Just say no” defense
• Poison puts
• Greenmail
• Incorporation in a state with
restrictive takeover laws
• Share repurchase
• Staggered board of directors
• Restricted voting rights
• Supermajority voting provisions
• Fair price amendments
• Golden parachutes
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• Litigation
• Leveraged recapitalization
• “Crown jewels” defenses
• “Pac-Man” defense
• White knight defense
• White squire defense
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6. REGULATION
Antitrust
Law
Securities
Law
Regulation
of Mergers
and
Acquisitions
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ANTITRUST LAW: UNITED STATES
Sherman Antitrust Act (1890)
• Made combinations, contracts, and conspiracies in restraint of trade or
attempts to monopolize illegal
Clayton Antitrust Act (1914)
• Outlawed specific business practices
Celler–Kefauver Act (1950)
• Closed loopholes in the Clayton Act
Hart–Scott–Rodino Antitrust Improvements Act
(1976)
• Gave the FTC and the Justice Department an opportunity to review
and challenge mergers in advance
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ANTITRUST
• The European Commission reviews combinations for antitrust issues.
• Regulatory bodies besides the FTC may review combinations (e.g., U.S.
Federal Communications Commission, Federal Reserve Bank, state insurance
commissions).
• If the combination involves companies in different countries, it may require
approvals by all countries’ regulatory bodies.
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THE HHI
• The Herfindalhl–Hirschman Index (HHI) is a measure of concentration within
an industry and is often used by regulators to evaluate the effects of a merger.
• The HHI is constructed as the sum of the squared market shares of the firms in
the industry:
n
2
Output of firm i
HHI =
× 100
Total sales or output of the market
i
HHI Concentration Level and Possible Government Action
Post-Merger HHI
Concentration
Change in HHI Government Action
Less than 1,000
Not concentrated
Any amount
No action
Between 1,000 and 1,800 Moderately concentrated 100 or more
Possible challenge
More than 1,800
Highly concentrated
50 or more
Challenge
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EXAMPLE: HHI
Consider an industry that has six companies. Their respective market shares are
as follows:
Company
Market Share
A
25%
B
15%
C
15%
D
15%
E
15%
F
15%
100%
What is the likely government action, if any, if Companies E and F combined?
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EXAMPLE: HHI
Market
Company Share
HHI
Before
Market
Company Share
HHI
After
A
25%
625
A
25%
625
B
15%
225
B
15%
225
C
15%
225
C
15%
225
D
15%
225
D
15%
225
E
15%
225
E+F
30%
900
F
15%
225
Total
100%
1125
Total
100%
1575
• The industry would be considered moderately concentrated before and after
the combination of E and F, and
• The change in the HHI is 450, which may result in a government challenge.
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SECURITIES LAWS: UNITED STATES
• Williams Act (1968):
- Requires public disclosure when a party acquires 5% or more of a target’s
common stock.
- Specifies rules and restrictions pertaining to a tender offer.
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7. MERGER ANALYSIS
• The discounted cash flow (DCF) method is often used in the valuation of the
target company.
• The cash flow that is most appropriate is the free cash flow (FCF), which is the
cash flow after capital expenditures necessary to maintain the company as an
ongoing concern.
• The goal is to estimate future FCF.
- We can use pro forma financial statements to estimate FCF
- We use a two-stage model when we can more accurately estimate growth in
the near future and then assume a somewhat slower growth out into the
future.
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ESTIMATING FREE CASH FLOW (FCF)
Calculate Net Interest after Tax
(Interest expense – Interest income) × (1 – Tax rate)
Calculate Unlevered Net Income
Net income + Net interest after tax
Calculate NOPLAT
Unlevered net income + Change in deferred taxes
Calculate FCF
NOPLAT + Noncash charges – Change in working capital – Capital expenditures
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EXAMPLE: FCF FOR THE ABC COMPANY
Suppose analysts have constructed pro forma financial statements for the
ABC Company and report the following:
From the pro forma income statement
Net income
$40
From the pro forma income statement
Change in deferred taxes
Interest expense
$5
Depreciation
Interest income
$2
Change in working capital
Assumed
Capital expenditures
$3
$10
$6
$20
Tax rate = 45%
What is ABC’s free cash flow?
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EXAMPLE: FCF
Net income
Plus
Net interest after tax
Equals
Unlevered net income
Plus
Change in deferred taxes
Equals
Net operating profit minus adjusted taxes
Plus
Depreciation
Minus
Change in working capital
Minus
Capital expenditures
Equals
Free cash flow
Copyright © 2013 CFA Institute
$40.00
1.65
$41.65
3.00
$44.65
10.00
6.00
20.00
$28.65
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DISCOUNTED CASH FLOW (DCF) AND
THE TERMINAL VALUE
We can estimate the terminal value:
- Assuming a constant growth after the initial few years or
- Assuming a multiple (based on comparables) of pro forma FCF for the last
estimated year.
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THE DCF METHOD
• Advantages of using the DCF method:
- The model allows for changes in cash flows in the future.
- The cash flows and estimated value are based on forecasted fundamentals.
- The model can be adapted for different situations.
• Disadvantages of using the DCF method:
- For a rapidly growing company, the FCF and net income may be misaligned
(e.g., higher-than-normal capital expenditure).
- Estimating future cash flows is difficult because of the uncertainty.
- Estimating discount rates is difficult, and these rates may change over time.
- The terminal value estimate is sensitive to the assumptions and model used.
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COMPARABLE COMPANY ANALYSIS
Select Comparable Companies
• Publicly traded companies that are similar to the subject company
• Same or similar industry
Calculate Relative Value Measures
• Enterprise value multiples
• Price multiples
Apply Metrics to Target
• Judgment needed to select appropriate metric
Estimate Takeover Price
• Takeover premium added
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EXAMPLE: COMPARABLE COMPANY ANALYSIS
Suppose an analyst has gathered the following information on the target
company, the XYZ Company:
XYZ Company
Average of Comparables
Earnings
$10 million
P/E of comparables
30 times
Cash flow
$12 million
P/CF of comparables
25 times
Book value of equity
$50 million
P/BV of comparables
2 times
Sales
$100 million
P/S of comparables
2.5 times
If the typical takeover premium is 20%, what is the XYZ Company’s value in a
merger using the comparable company approach?
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EXAMPLE: COMPARABLE COMPANY ANALYSIS
Assuming that the average of the values from the different multiples is most
appropriate:
Comparables’
Multiples
Estimated
Stock Value
Earnings
$10 million ×
30
$300 million
Cash flow
$12 million ×
25
$300 million
Book value of equity
$50 million ×
2
$100 million
$100 million ×
2.5
$250 million
Sales
Average =
$237.5 million
Estimated takeover price of the XYZ Company = $237.5 million × 1.2 = $285 million
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COMPARABLE COMPANY ANALYSIS
• Advantages
- Provides reasonable estimate of the target company’s value
- Readily available inputs
- Estimates based on market’s value of company attributes
• Disadvantages
- Sensitive to market mispricing
- Sensitive to estimate of the takeover premium, and historical premiums may
not be accurate to apply to subsequent mergers
- Does not consider specific changes that may be made in the target postmerger
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COMPARABLE TRANSACTION ANALYSIS
Collect
Information on
Recent Takeover
Transactions of
Comparable
Companies
Copyright © 2013 CFA Institute
Calculate
Multiples for
Comparable
Companies
Estimate
Takeover Value
Based on
Multiples
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EXAMPLE: COMPARABLE
TRANSACTION ANALYSIS
Suppose an analyst has gathered the following information on the target
company, the MNO Company:
MNO Company
Average of Multiples of
Comparable Transactions
Earnings
$10 million
P/E of comparables
15 times
Cash flow
$12 million
P/CF of comparables
20 times
Book value of equity
$50 million
P/BV of comparables
5 times
P/S of comparables
3 times
Sales
$100 million
Estimate the value of the MNO Company using the comparable transaction
analysis, giving the cash flow multiple 70% and the other methods 10% each.
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EXAMPLE: COMPARABLE
TRANSACTION ANALYSIS
Comparables’
Transaction
Multiples
Estimated
Stock Value
Earnings
$10 million ×
15
$150 million
Cash flow
$12 million ×
20
$240 million
Book value of equity
$50 million ×
5
$250 million
$100 million ×
3
$300 million
Sales
Value of MNO = 0.7 × $240 + 0.1 × $150 + 0.1 × $250 + 0.1 × $300
Value = $238 million
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COMPARABLE TRANSACTION ANALYSIS
• Advantages
- Does not require specific estimation of a takeover premium
- Based on recent market transactions, so information is current and observed
- Reduces litigation risk
• Disadvantages
- Depends on takeover transactions being correct valuations
- There may not be sufficient transactions to observe the valuations
- Does not include value of changes to be made in target
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EVALUATING BIDS
The acquiring firm shareholders want
to minimize the amount paid to target
shareholders, not paying more than
the pre-merger value of the target plus
the value of the synergies.
The target shareholders want to
maximize the gain, accepting nothing
below the pre-merger market value.
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EVALUATING BIDS: FORMULAS
Target shareholders’ gain = Premium = PT – VT
(10-7)
where
PT = price paid for the target company
VT = pre-merger value of the target company
Acquirer’s gain = Synergies – Premium = S – (PT – VT)
(10-8)
where
S = synergies created by the business combination
VA* = VA + VT + S – C
(10-9)
where
VA* = post-merger value of the combined companies
VA = pre-merger value of the acquirer
C = cash paid to target shareholders
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EXAMPLE: EVALUATING BIDS
Suppose that the Big Company has made an offer for the Little Company that
consists of the purchase of 1 million shares at $18 per share. The value of Little
Company stock before the bid was made public was $15 per share. Big
Company stock is trading at $40 per share, and there are 10 million shares
outstanding. Big Company estimates that it is likely to reduce costs through
economics of scale with this merger of $2 million per year, forever. The
appropriate discount rate for these gains is 10%.
1. What are the synergistic gains from this merger?
2. What parties, if any, share in these gains?
3. What is the estimated value of the Big Company post-merger?
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EXAMPLE: EVALUATING BIDS
1. Synergistic gains = $2 million  0.10 = $20 million
2. Division of gains: First calculate the gains for each party and then evaluate
the division.
Target shareholders gain = $18 million – $15 million = $3 million
Acquirer’s gain = $20 million – 3 million = $17 million
Little shareholders get $3 million  $20 million = 15% of the gain
Big shareholders get $17 million  $20 million = 85% of the gain
3. Value of Big Company post-merger
= $400 million + $15 million + $20 million – $18 million = $417 million
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EFFECTS OF PRICE AND PAYMENT METHOD
• The more confidence in the realization of synergies,
- the greater the chance that the acquiring firm will pay cash and
- the more the target company shareholders will prefer stock.
• The greater the use of stock in a deal,
- the greater the burden of the risks borne by the target shareholders and
- the greater the potential benefits accrue to the target shareholders.
• The greater the confidence of the acquiring firm managers in estimating the
value of the target, the more likely the acquiring firm is to offer cash.
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8. WHO BENEFITS FROM MERGERS?
• Mergers create value for the target company shareholders in the short run.
• Acquirers tend to overpay in merger bids.
- The transfer of wealth is from acquirer to target company shareholders.
- Roll: Overpayment results from “hubris.”
• Acquirers tend to underperform in the long run.
- They are unable to fully capture any synergies or other benefit from the
merger.
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MERGERS THAT CREATE VALUE
• Buyer is strong.
• Transaction premiums are relatively low.
• Number of bidders is low.
• Initial market reaction to the news is favorable.
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9. CORPORATE RESTRUCTURING
A divestiture is the sale, liquidation, or spin-off of a division or subsidiary.
Equity
Carve-Out
Liquidation
Spin-Off
Parent
compan
y
Divestiture
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Split-Off
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REASONS FOR RESTRUCTURING
• Companies generally increase in size with a merger or acquisition.
• Restructuring, which includes divestitures, generally follows periods of merger
and acquisitions.
• Reasons for restructuring:
- Change in strategic focus
- Poor fit
- Reverse synergy
- Financial or cash flow needs
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FORMS OF DIVESTITURE
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10. SUMMARY
• An acquisition is the purchase of some portion of one company by another,
whereas a merger represents the absorption of one company by another.
• Mergers may be a statutory merger, a subsidiary merger, or a consolidation.
• Horizontal mergers occur among peer companies engaged in the same kind of
business, vertical mergers occur among companies along a given value chain,
and conglomerates are formed by companies in unrelated businesses.
• Merger activity has historically occurred in waves.
- Waves have typically coincided with a strong economy and buoyant stock
market activity.
- Merger activity tends to be concentrated in a few industries, usually those
undergoing changes.
• There are number of motives for a merger or acquisition; some are justified,
some are dubious.
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SUMMARY (CONTINUED)
• A merger transaction may take the form of a stock purchase or an asset
purchase.
- The decision of which approach to take will affect other aspects of the
transaction.
• The method of payment for a merger may be cash, securities, or a mixed
offering with some of both.
• Hostile transactions are those opposed by target managers, whereas friendly
transactions are endorsed by the target company’s managers.
• There are a variety of both pre- and post-offer defenses a target can use to
ward off an unwanted takeover bid.
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SUMMARY (CONTINUED)
• Pre-offer defense mechanisms include poison pills and puts, incorporation in a
jurisdiction with restrictive takeover laws, staggered boards of directors,
restricted voting rights, supermajority voting provisions, fair price amendments,
and golden parachutes.
• Post-offer defenses include “just say no” defense, litigation, greenmail, share
repurchases, leveraged recapitalization, “crown jewel” defense, “Pac-Man”
defense, or finding a white knight or a white squire.
• Antitrust legislation prohibits mergers and acquisitions that impede competition.
• The Federal Trade Commission and Department of Justice review mergers for
antitrust concerns in the United States. The European Commission reviews
transactions in the European Union.
• The Herfindahl–Hirschman Index (HHI) is a measure of market power based
on the sum of the squared market shares for each company in an industry.
• The Williams Act is the cornerstone of securities legislation for M&A activities in
the United States.
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SUMMARY (CONTINUED)
• Three major tools for valuing a target company are discounted cash flow
analysis, comparable company analysis, and comparable transaction analysis.
• In a merger bid, the gain to target shareholders is the takeover premium. The
acquirer gain is the value of any synergies created by the merger, minus the
premium paid to target shareholders.
• The empirical evidence suggests that merger transactions create value for
target company shareholders, yet acquirers tend to accrue value in the years
following a merger.
• A divestiture is a transaction in which a company sells, liquidates, or spins off a
division or a subsidiary.
• A company may divest assets using a sale to another company, a spin-off to
shareholders, or a liquidation.
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