10. Mergers and Acquisitions: Lecture 10 Chap 24

• Mergers and Acquisitions are covered
• This is Lecture 10

Learning Objectives

• Types of mergers and trends in merger activity are discussed
• Stock price reactions to takeover announcements are understood
• Reasons to acquire are evaluated
• Major steps in the takeover process are followed
• Main takeover defenses are discussed
• Factors that determine who gets the value-added in a merger are identified

Background and Historical Trends

• Corporate control market exists
• The acquirer is also known as a bidder
• The target of the acquisition attempt
• Acquisition
• Merger
• Peaks of heavy takeover activity are followed by troughs of few transactions in merger waves
• Merger activity is greater during economic expansions compared to contractions
• Merger activity correlates with bull markets

Merger Waves

• Mergers occur in distinct waves
• Recent waves occurred in the 1980s, 1990s, and 2000s

Types of Mergers

• Horizontal mergers involve targets and acquirers in the same industry
• Vertical mergers occur when a target's industry supplies to or buys from the acquirer's industry
• Conglomerate mergers involve targets and bidders in different industries
• Stock swap involves target shareholders exchanging old stock for new stock
• Cash merger or acquisition involve payments that can be very complex, typically a mix of payment forms

Market Reaction to Takeover

• Acquisition premium is the extra amount paid above the pre-merger price to acquire a company
• On average, the premium paid over pre-merger price is 43%
• The announcement price reaction for the target is 15%
• The announcement price reaction for the acquirer is 1%

Key Questions About Takeovers

• Why do acquirers pay a premium?
• Why does the target's price rise by less than the premium?
• Why does the acquirer's price not increase much, even if the merger is a good idea?

Reasons to Acquire

• Synergies may enable the acquirer to add economic value following the acquisition.
• Economies of Scale: Producing goods in high volume leads to savings
• Economies of Scope: Marketing and distributing related products saves money
• Vertical Integration combines companies in the same industry that make products required at different production cycle stages
• The principal benefit of vertical integration is coordination

Reasons to Acquire, Continued

• Purchasing a company for its existing talent pool is more efficient
• Monopoly gains are subject to antitrust laws
• Efficiency gains achieved through elimination of duplication
• Efficiency gains achieved through improvement in poor management
• Tax savings can result from operating losses
• A tax loss must have a profit elsewhere to be written off
• Losses in one division offset profits in another division

Taxes for a Merged Corporation

• Consider Yin Corporation and Yang Corporation
• Both corporations, with equal probability, either make $50 million or lose $20 million each year
• The firms' profits are perfectly negatively correlated
• Yang Corporation earning $50 million leads to Yin Corporation losing $20 million, and vice versa
• The corporate tax rate is 34%
• Determining expected after-tax profits of both firms as separate entities versus a combined entity

Taxes for a Merged Corporation, Continued

• After-tax profits must be calculated for each firm, both profitable and unprofitable, using the equation (1 - tax rate).
• Expected after-tax profits computed as the weighted average of after-tax profits in profitable and unprofitable states
• If the firms combined, total profits in any year would be $30 million
• The after-tax profit is $30 million × (1 – tax rate)

Yin Corporation Tax Example

• Yin Corporation must pay corporate taxes, so after-tax profits are $50 × (1 – 0.34) = $33 million when profitable
• No taxes are owed when the firm reports losses, so the after-tax profits in the unprofitable state are -$20 million
• Expected after-tax profits of Ying Corporation equal $6.5 million
• Stand-alone after-tax profits total $13 million
• Yin-Yang Corporation would have after-tax profits of $19.8 million when merged
• Merged firms have higher after-tax profits than stand-alone firms due to the offset of taxes

Reasons to Acquire, Earnings Growth

• Combining two companies can result in higher earnings per share than premerger, even without economic value creation
• Acquiring a low-growth potential company can increase a high-growth company's earnings per share
• High-growth company lowers overall growth rate when combining with low-growth company

Mergers and Earnings Per Share Context

• Two corporations, both earn $5/share
• OldWorld Enterprises: Mature company with few growth opportunities
• Oldworld has 1 million shares at $60 per share
• NewWorld Corporation: Young company with many growth opportunities
• NewWorld has 1 million shares at $100 per share
• Assume NewWorld acquires OldWorld using its own no value is added
• Determination of NewWorld market value after acquisition

Mergers and Earnings Per Share Math

• Post-takeover value of NewWorld is $160 million
• To acquire OldWorld, NewWorld must pay $60 million
• Calculate the shares NewWorld must issue to pay OldWorld shareholders
• The ratio of NewWorld shares issued to OldWorld shares is the exchange ratio
• Divide the combined company’s total earnings by the new total outstanding shares to get the earnings per share

Mergers and Earnings Per Share, The Details

• At $100 pre-takeover stock price, the deal involves issuing 600,000 shares
• OldWorld’s shareholders exchange 1 million shares in OldWorld for 600,000 shares in NewWorld
• The exchange ratio is 0.6
• Each OldWorld shareholder gets 0.6 shares in NewWorld for each OldWorld share
• New World's new value of $160 million and 1.6 million shares are outstanding
• New World's resulting stock price is $100 per share
• Prior to the takeover, both companies earned $5/share × 1 million shares = $5 million

Mergers and Earnings Per Share Results

• The combined corporation earns $10 million
• NewWorld's post-takeover earnings per share is $6.25/share
• EPS = $10 million / 1.6 million shares
• By acquiring OldWorld, NewWorld raised its earnings per share by $1.25
• However, no value increased in this acquisition
• Combining OldWorld with the high-growth New World lowers growth
• The higher earnings per share entails lower earnings per share growth

Mergers and Price-Earnings Ratio

• The price-earnings ratio requires calculation before and after the takeover
• The price-earnings ratio is: Price per share / earnings per share
• NewWorld's price per share is $100 before and after, with earnings per share of $5 before and $6.25 after
• Before the takeover, NewWorld's price-earnings ratio is 20
• Formula: P/E = $100/share / $5/share
• After the takeover, NewWorld's price-earnings ratio is 16
• Formula: P/E = $100/share / $6.25/share

Mergers and Price-Earnings Ratio, Continued

• The price-earnings ratio drops after the takeover
• The ratio reflects a shift in NewWorld's valuation
• More of NewWorld's value comes from current earnings rather than future growth potential

Reasons to Acquire, Management

• Larger company is more prestigious
• Conflicts of interest drive managerial motives to merger
• Overconfidence leads CEOs to pursue unsuccessful mergers

Takeover Process: Valuation

• Compare the target to similar firms, rough estimate
• Discounted cash flows, harder to implement, includes synergies

Takeover Process: The Offer

• Public announcement
• Cash transaction
• Stock swap
• Exchange ratio
• Offers a positive NPV transaction; share price of merged firm exceeds premerger acquirer price

Takeover Process Formulas

• Stock swap positive NPV calculation: (A+T+S)/(Nᴀ+x) > A/Nᴀ, where:
• A = premerger value of acquirer
• T = premerger value of target
• S = value of synergies
• Nᴀ = shares outstanding of acquirer premerger
• x = number of shares issued in the merger
• Maximum value of x to yield positive NPV: x < ((T+S)/A)Nᴀ
• Exchange Ratio = x/Nᴛ < (T+S)/A * Nᴀ/(Nᴛ), where Nᴛ = premerger # target shares

Takeover Process Formulas, Continued

• Rewrite formulas using premerger target and acquirer share prices with
  • Pᴛ = T/Nᴛ
  • Pᴀ = A/Nᴀ
  • Exchange Ratio < (Pᴛ/Pᴀ)(1 + (S/T))

Example Maximum exchange ratio of Sprint/Nextel

• Sprint stock was $25/share, Nextel $30/share (Dec 2004)
• Projected synergies were $12 billion, Nextel had 1.033 billion shares outstanding
• Calculate max exchange ratio Sprint could offer in a stock swap with positive NPV
• What's the maximum cash offer Sprint could make?

Takeover Process Example Math

• Sprint offering $25/share
• Nextel valued $30/share
• Synergies are $12 Billion
• 1.033 Billion Nextel shares
• Formula: Exchange Ratio < (Pᴛ/Pᴀ)(1 + (S/T)) => (30/25)*(1 + (12 Billion/31 Billion)) = 1.665
• That is, Sprint offering 1.665 shares of Sprint stock for each share of Nextel generates a positive NPV
• For cash offer: $12 Billion /1.033 = $11.62 per share synergy value so Sprint offers $30 + $11.62 = $41.62

Takeover Results for Nextel

• Both amounts, the cash amount and the exchange offer, are worth $41.62
• That is the highest Sprint can pay
• Sprint is paying full price & Nextel shareholders get paid the full synergy gains
• At $41.62, this is a zero-NPV project

Takeover Process: Considerations

• Tax and accounting issues
• Form of payment affects taxes to target shareholders and combined firm
• Cash received triggers immediate tax liability
• Stock swap defers taxes until shares are sold
• Step up: increase in book value of target’s assets
• The increase occurs when acquirer purchases those assets directly instead of stock
• Results in higher depreciable basis reduces future taxes
• Goodwill can be amortized

Takeover Process: Approval

• Obtaining the approval of the Board and shareholders
• Friendly takeover
• Hostile takeover
• Known as Corporate raider
• Board may reject even with an offered premium
• They may think the offer is too low
• Stock swap, might think acquirer is overvalued
• Conflict of interest, agency problem
• May lead to many management changes

In Theory Target Responsibilities

• Duty to act in the interest of shareholders
• Revlon duties
• Must seek the highest value
• Unocal: actions are subject to scrutiny, cannot be coercive or preclude a deal

Takeover Defenses: Proxy Fight

• In proxy fights, the acquirer tries to convince the target shareholders to use proxy votes
• The votes needed to support an acquirer’s candidates for election to the target board
• Force bidder to pay more
• Secure entrenchment

Takeover Defenses: Poison Pills

• Poison pills involve rights offering
• Exisiting target shareholders can buy shares in target at deeply reduced rate if takeover occurs
• Makes it hard to replace bad managers
• Firm’s stock drops when adopted
• Firms underperform

Takeover Defenses: Staggered Boards and More

• Staggered boards are when board of directors' terms are staggered
• Only one-third of the directors come up for election each year
• White knights are when the target looks for a friendlier company to acquire it
• White squire exist when a large, passive investor or firm agrees to purchase a stock block for special voting rights
• Golden parachutes guarantee lucrative severance package to senior managers
• Golden parachutes increase value because management more receptive to an acquisition.

Takeover Defenses: Regulatory and Defensive

• Recapitalization is when an attractive company changes the capital structure
• Paying out a large dividend
• Supermajority
• Restricted voting rights for large shareholders
• “Fair” price
• Regulatory approval
• Sherman Act
• Clayton Act
• Hart-Scott-Rodino Act

Valued Added in Takeover Context

• HighLife Corporation has 1 million shareholders, 1 share each
• Management performs poorly + Shares trade at a deep discount because of it
• Management could be worth $75 per share if things improve, they trade at $45
• A simple majority passes decisions, so 50% grants takeover rights
• T. Boone makes a $60 per share offer
• A simple majority means T. Boone is profitable at $15 /share, even when performance improves.

Value Added In Takeover, Continued

• Tendering makes a profit ($60-$45)
• Remaining shareholders make ($75-$45) by letting them tender
• They expect that tender will succeed, so nothing offered by T. Boone will succeed
• Unless Boone raises offer such as $75
• Raider gives up profit
• Existing shareholders free ride due to zero expenditure/time

Initial Stake and Corporate Raider Takeovers

• Toeholds refers to initial ownership stake for corporate raiders to takeover
• T. Boone can acquire up to 10% of firm in secret
• Then buy 40% @ $75, makes profit from initial stake
• Raiders provide key service because management knows they exist

Leverage Buyout Process

• Leveraged buyout provides less costly option for corporate raiders
• A $50 per share offer is announced by T. Boone for half the outstanding shares
• Without using his money he borrows with a shell corp using shares as collateral
• If successful, he merges the shares and debt is obtained toward the target
• Shareholders tender: outstanding debt makes post share price at $50

Leveraged Buyout Example, FAT Corporation

• FAT Corporation stock is $40 per share and 20 million shares outstanding, and no debt
• A partner in buyouts sees the company is ripe to improve
• Capable hires will lead to 50% value increase
• At least 50% control is sought with payout
• How much value can be extracted, while dealing?

Leverage Buyout Example, Math

• Current value $40 multiplies by $20 million adds to $800 million
• A 50% increase yields $400 Million
• Borrowing $400 million makes new management possible
• The company will now be worth $1.2
• Debt makes it $400 million debt
• The value of equity post-takeover matters a great deal.
• Confirm that your gain on debt/other metrics will not change.

Leveraging Profit: Example

• The value of equity $1200 million less debt leads to $800 million
• What occurred pre-merger
• By owning half for nothing, you captured the value anticipated adds to FAT

Using Debt: Example

• At borrowing of $450 Million
• New total equity $1200 less $450
• Shareholders would need to be offered at least the pre-merger price for their shares.
• Knowing that share prices will drop later, they will agree

The End of Debt: LBO

• $800M must be paid at offer price. $800m in shares minus debt is $350m "out of pocket"
• $750 Million in new value leads to $400 in Million profits
• The gain is directly tied amount "added" to deal, no more

Freezout Merger Value

• Used by acquirers, where smaller investors buyout others
• Loan leveraging is applied with investors
• A slight premium offer is made
• With success, merger runs into the parent structure leading gains in control
• Non Tendering is rewarded the offer reward with shares

Competitive Value

• Competition drives prices and deals to the best reward
• If pricing does not meet the value metric, then another party will provide offer

Summary of Mergers and Aquisitions

• Horizontal, vertial or conglomerate traits
• Merger occur cyclical
• Synergies commonly influence deal
• Valuation processes and steps in acquisition
• The director's role is influence merger outcome- poison pill, stagger board, white knight
• Outcome beneficiaries can be complex