Principles of Corporate Finance

Chapter 32

Eighth Edition

Mergers

Slides by Matthew Will

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Topics Covered
Sensible Motives for Mergers Some Dubious Reasons for Mergers Estimating Merger Gains and Costs The Mechanics of a Merger Takeover Battles and Tactics Mergers and the Economy

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Recent Mergers
Industry Cement Cement Petrochemicals Petrochemicals Technology Technology Acquiring Company Holdcem Cements Pvt Limited Grasim Indian Oil Reliance Industries Oracle Global (Mauritius) Maxis Communications Berhad and Prathap Reddy (promoter of Apollo Hospital) Selling Company Ambuja Cement Ultratech Cement IBP Controlling Stake in IPCL I-Flex Solutions Aircel Payment (Rs. Crores) 4885 1641 1841 2638 3955 4860

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Sensible Reasons for Mergers

Economies of Scale
A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units.

Reduces costs

Rs.
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Sensible Reasons for Mergers

Economies of Vertical Integration Control over suppliers may reduce costs. Over integration can cause the opposite effect.
Pre-integration (less efficient)
Company S S S S

Post-integration (more efficient)

Company

S
S S
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Sensible Reasons for Mergers

Combining Complementary Resources Merging may results in each firm filling in the missing pieces of their firm with pieces from the other firm.
Firm A

Firm B
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Sensible Reasons for Mergers

Mergers as a Use for Surplus Funds If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.

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Dubious Reasons for Mergers

Diversification
Investors should not pay a premium for diversification since they can do it themselves.

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Dubious Reasons for Mergers

The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to low number of shares) After merger, acquiring firm has short term EPS rise Long term, acquirer will have slower than normal EPS growth due to share dilution.

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Dubious Reasons for Mergers

The Bootstrap Game
World Enterprises (after buying Muck and Slurry) Muck and Slurry $ 2.00 $ 2.67 $ 20.00 $ 40.00 10 15 100,000 150,000 $ 200,000 $ 400,000 $ 2,000,000 $ 6,000,000

World Enterprises (before merger) EPS Price per share P/E Ratio Number of shares Total earnings Total market value Current earnings per dollar invested in stock $ $ 2.00 40.00 20 100,000 200,000 4,000,000

$ $

0.05 $

0.10 $

0.067

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Dubious Reasons for Mergers

Earnings per dollar invested (log scale)

World Enterprises (after merger)

World Enterprises (before merger) Muck & Slurry

.10 .067 .05 Now Time

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Estimating Merger Gains

Questions
Is there an overall economic gain to the merger? Do the terms of the merger make the company and its shareholders better off?

????

PV(AB) > PV(A) + PV(B)

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Estimating Merger Gains

Gain PVAB ( PVA PVB ) PVAB Cost Cash paid PVB NPV gain lost PVAB ( cash PVB )

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Estimating Merger Gains

Example Two firms merge creating Rs.25 million in synergies. If A buys B for Rs.65 million, the cost is Rs.15 million.

PVA Rs.200 PVB Rs.50 Gain PVAB Rs.25 Cost Cash paid PVB 65 50 Rs.15million
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Estimating Merger Gains

Economic Gain

Economic Gain = PV(increased earnings) New cash flows from synergies discount rate

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Accounting for a Merger

Accounting for the merger of A Corp and B Corp
Initial Balance Sheets NWC FA A Corporation 20 80 100 30 70 100 D E NWC FA B Corporation 1 0 9 10 10 10 D E

Balance Sheet of AB Corporation (Pooling of Interests Method) NWC 21 30 D FA 89 80 E 110 110

Balance Sheet of AB Corporation (Purchase Method) NWC 21 30 D FA 89 88 E Goodwill 8 110 110

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IT Act and Mergers in India

Income Tax Act Sec 2 (1B) Benefits under these acts (which the merging company was getting prior to the merger) will continue to be available to the merged company, when merger satisfies the conditions laid down under Section 2(1B) If a profit making company acquires a loss making company, then it can continue to carry forward the business losses subject to certain considitions (including Section 32 of SICA) Explains when the exchange of shares in case of mergers will not be treated as capital gains Mergers Explains which mergers will get some tax benefits under Section 35

Sec 35 (5), 35A(6), 35D(5), 35E(7) Sec 72A Section 47

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Phillips Case
Philips balance sheet was dramatically changed by its leveraged restructuring (figures in $billions).

1985 Current assets Fixed assets Other Total assets $3.10 10.30 0.60 14.00

1984 $4.60 11.20 1.20 17.00 Current liabilities Long-term debt Other long-term liabilities Equity Total liabilities

1985 $3.10 6.50 2.80 1.60 14.00

1984 $5.30 2.80 2.30 6.60 17.00

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Takeover Methods
Tools Used To Acquire Companies
Proxy Contest Tender Offer

Acquisition

Merger

Leveraged Buy-Out

Management Buy-Out

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Takeover Defenses
White Knight - Friendly potential acquirer sought by a target company threatened by an unwelcome suitor. Shark Repellent - Amendments to a company charter made to forestall takeover attempts. Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.

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Web Resources
Click to access web sites Internet connection required

www.cfonews.com www.mergernetwork.com www.mergerstat.com www.globalfindata.com

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