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Financial Management MGT201

Lesson 43

MERGERS AND ACQUISITIONS

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following topic:

· Mergers & Acquisitions (M&A)

Mergers & Acquisitions (M&A):

· The buying & selling of entire firms or divisions of firms is a specialized art in finance.

· Why firms Merge?

Diversification:

· Reduce Risk and Stabilize Earnings, attain Economies of Scale

· Achieve Long Term Strategic Goals, Gain Larger Market Share and Quick

Growth in size,

Improving Financials: quick way to improve the Balance Sheet and Cash Flows

Find Cash: if another firm has large cash flows, cash reserves or liquid assets

· Cherry Picking: It means when Market Value of another similar firm is less

than cost of replacing your own assets it might be better to buy another firm

· Asset Stripping: separate out the non-profitable and sell its assets individually

to generate cash and restore profitability

Agency Cost: Desire of Managers for Prestige, Power, and Salary sometimes at expense

of Shareholders (Owners)

· Winning Management Control (exercise influence on Board). Manager

Salaries Rise (larger firm, Agency Costs). Fear of Losing Job if Taken Over by

Rival Firm.

· How do you pay for (or finance) buying a Firm?

Cash, Stock or Shares, Bank Borrowing or Debt (LBO's) or Combination

· "Merger" When 2 or more Firms combine to form 1 Firm.

· Benefit of Merger Synergy:

2+2 = 5!

It means value of a combined firm after merger is more than the firms' value individually before

the merger

· 2 Broad Categories of Mergers:

· Pure Financial Merger - Operations remain independent

· Operating Merger - Operations are Integrated & Changed & Synergies

Expected

· 4 Specific Types of Mergers:

· Horizontal Merger: merger of 2 competitors - can lead to Monopoly

· Vertical Merger: merger of a supplier with a buyer

· Co generic Merger: merger of firms in same industry

· Conglomerate Merger: merger of firms in unrelated industries

· "Acquisition": Most common form of Merger.

· When a Firm buys another Firm. This acquisition Can be "Hostile" Raid or "Friendly"

· The firm that acquires the other firm is known as acquirer firm but the firm which is acquired is

known as Target firm

· "Divestiture" = Reverse Merger. Benefit of Efficient Reallocation of Resources:

5 - 1 = 5!

It means by selling an inefficient or unproductive unit of the company you can have more value

as it saves costs

· "Sell off" - Sale (transfer Ownership) of a Division of a Firm

· "Spin off" - transfer Management Control of a Division of a Firm

· "Liquidation" - Sale of assets to pay off Shareholders

Merger Issues & Regulations:

· Monopoly (Concentration of Power and Market Share)

Horizontal or Vertical Merger of 2 giants.

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Financial Management MGT201

Laws vary from country to country i.e. Anti-Trust Laws

Hostile Acquisitions (or Takeovers) by Corporate Raiders

2 Basic Ways of Hostile Takeovers:

· Canvassing general public shareholders for their Proxy Votes

· Limited-time Share Tender Offer by Raider at share price above the market

Corporate raiders urge the shareholders to buy their shares.

How Target Firm can Respond to Hostile Raid

· Poison Pill Target Firm takes on excessive short-term debt to appear

unhealthy. Because of high liabilities their balance sheet becomes unattractive.

· White Knight a wealthy friendly investor who protects the Target Firm by

making higher counter-tender offer against the corporate Raider.

· Fight Back: Target Firm makes counter-tender offer to shareholders

· Be Acquired (if Raider is offering much higher value than Firm is worth)

Target Firm need protection under law Shareholders might lose ownership and

Employees might lose their jobs.

Leveraged Buy-Outs (LBO's):

· Mechanism of Leveraged Buy-Outs (LBO's) using Debt Financing: Acquiring Firm borrows a

lot of money (from Debt Investors) to buy the shares of another publicly traded Target Firm.

The Public Firm thus becomes "Privatized" in the hands of fewer shareholders and it also means

less administrative costs. It then sells assets (Asset Stripping) of the Target to make immediate

interest payments. If Firm runs into difficulty, then can raise more money by selling its own

Junk Bonds. After Restructuring, Cost Cutting, and Down-Sizing, the firm (now financially

stronger) again goes Public giving opportunity for its stakeholders and deal-makers and

Investment Bank Advisers to recover their Investment and en cash Capital Gains.

· Possible Advantages of LBO: Debt increases Tax Shield Savings, Leverage can improve ROE,

and forces cost cutting measures by Management

· Management Buyouts & "Going Private": A type of LBO. Management buys all or most of

publicly held shares of their own firm and effectively converts public firm into a privately held

one.

Mergers - Good or Bad?

· Impact of Mergers on Market, Shareholder, & Employees

Temporary Increase in Stock Price because of competing Tender Offers by Buyer.

Wrong signals distort market prices.

Target Firms forced to take Drastic Measures to defend themselves i.e. Poison Pills.

Waste of Firm's resources and Value.

Mergers often followed by Cost Cutting, Streamlining which can improve Operational

Efficiency & Add Synergy. BUT, Down-sizing of Employees or Job Cuts can lead to

serious social problem

Numerical Valuation of a Target Firm Merger Analysis & Valuation:

· 2 Basic Approaches to Mergers Analysis and Valuation

Discounted Cash Flows (DCF)

Market Multiple Analysis (MMA)

· Discounted Cash Flows (DCF) uses NPV: We used in Capital Budgeting

o Estimate Post Merger Performa (Forecasted) Net After-Tax Incremental Cash Flows

(CF's) of Target Firm for 5 Yrs or more. Account for Post Merger Change in

Operations impact on incremental Cash Flows.

o Use Old Present Value Equation:

PV = CF1 / (1+r) + CF2 / (1+r) 2 + CF3 / (1+r) 3 +...

o Discount Rate (r) or Cost of Capital for Prospective Investors (i.e. Shareholders of the

Acquiring Firm i.e. rEL) so focus on Equity Value of Target Firm (not Total Value)

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Financial Management MGT201

Use CAPM Theory / SML to estimate rE (Required Return on Equity for

Shareholders) from Beta (or Relative Market Risk) of Target Firm. Then rE,L =

rRF + (rM - rRF) x BetaL .

Note that BetaL = BetaU [1 + (1-Tc) (D/E)]

Tc = corporate tax rate

D = Debt

E = Equity

Numerical Valuation of Target Firm Market Multiple Analysis (MMA):

· Market Multiple Analysis (MMA) Approach to Merger Valuation is the most commonly used

because it is quick & easy. Approximate Formulas and Ad-hoc Rules of Thumb that change

with different Industries and change with Time depending on Macroeconomic Conditions in

country

· Example of Market Multiples used in Pakistan:

Established Brand and Financially Healthy Textile Spinning Mill:

Firm Value = 10 x Annual Net Income (or Earnings)

The figure 10 comes from stock market reports analysis.

Based on Current Average P/E Multiple for Textile Spinning Sector = Average Market Price of

Share / Average EPS = 10.0

Financially Strong Operational Software House:

Firm Value = 7 x Annual Sales

Operational Mobile Phone Company:

Firm Value = Rs.100000 x Number of Connections

Value of Property in Pakistan = 10 x Annual Rental Income

Impact of Merger Price on Value of the Firm:

· Impact of Merger Price on Value of Acquiring Firm:

If Negotiated Price for Target Firm > Fair Price (or DCF Value Estimate) for Target

Firm then Acquiring Firm's Shareholders will Lose Value.

It is so as shareholders are paying more than the fair worth of the target company.

· Impact of Merger Price on Value of Target Firm:

If Negotiated Price per share of target firm > Market Price of Target Firm's share in

Stock Exchange then Target Firm's Shareholders will Gain Value

Shareholders are being paid price much higher than firm worth.

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