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Mergers and Acquisitions

Introduction
When one company buys another. It is making an investment. Acquisition of one firm by another is, of course, an investment made under uncertainty. Go ahead with the purchase, if it makes a net contribution to shareholders wealth. When a firm is taken over, its management is usually replaced.

Merger A transaction where two firms agree to integrate their operations on a relatively coequal basis because they have resources and capabilities that together may create a stronger competitive advantage Acquisition A transaction where one firm buys another firm with the intent of more effectively using a core competence by making the acquired firm a subsidiary within its portfolio of businesses Takeover If management of one firm believes that another companys management is not acting in interest of investors, it can go over heads of that firms management and make tender offer directly to its stockholders.

The Merger Market


Tools Used To Acquire Companies
Proxy Contest Tender Offer

Acquisition

Merger

Leveraged BuyOut

Management Buy-Out

Proxy contest
Takeover attempt in which outsiders compete with management for shareholders votes (so called proxy fight) A proxy is the right to vote another shareholders share In a proxy contest, outsiders would like to take control with electing new board members

Mergers and Acquisitions

Three ways one firm to acquire another firm:


Merger Tender offer Acquisition

Merger

Combination of two firms into one, with the acquirer assuming assets and liabilities of the target firm. Merger must have approval of more than 50% of shareholders Horizontal merger-take place between two firms in the same line of business (two banks) Vertical merger-involves firms at different stages of production (raw materials and consumer products)

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. Opportunity to spread fixed costs across a larger volume of output.

Reduces costs
$

Sensible Reasons for Mergers


Combining Complementary Resources Usually small firms are acquired by large firms can be part of success too. Merging may results in each firm filling in the missing pieces of their firm with pieces from the other firm.
Firm A

Firm B

Dubious Reasons for Mergers


Diversification reduces risk, Diversification is easier and cheaper for shareholders than for the company Investors should not pay a premium for diversification since they can do it themselves

Evaluating Mergers

Questions
Is there an overall economic gain to the merger? (Value enhancing, worth two firms than apart) Do the terms of the merger make the company and its shareholders better off?

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

Evaluating Mergers

Economic Gain

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

Evaluating Mergers
Example - Given a 20% cost of funds, what is the economic gain, if any, of the merger listed below?
ABC Foods Targetco Combined Revenues 150 20 172 Operating Costs 118 16 132 Earnings 32 4 40

40 Ec onomic Gain = $200 .20


Additional value is the basic motivation for the merger.

Operating costs reduced as combining companies marketing, administration and distribution departments. Projected revenues will be increased Increased earnings are the only synergy to be generated by the merger.

Tender offer
It is a takeover attempt in which outsiders directly offer to buy the stock of the firms shareholders With this method acquiring firm (investors) can bypass the target firms management

Leveraged Buy-Outs
LBO-Acquisition of a firm by private group of investors using borrowed debt. Unique Features of LBOs:Large portion of buy-out financed by debt Shares of the LBO no longer trade on the open market

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