M&As (Class4)

MERGERS AND ACQUISITIONS
M&As are financial transactions that involve a change in

the control of a company:
Control Change
Operation Changes:
- New controlling shareholders
- New board of directors
- New management
- New business strategy
M&As are a consequence of changing markets and

competitive environments

The buyer or acquiror may be:
- An operating company (the most common)
- A group of managers
- A group of financial investors
- A combination of the three
The seller side may be:
- The board of directors
- A controlling shareholder

Financial Justification:
The acquisition will increase the per-share value of the
acquirer over the long term
OR
Cash Flows from the transaction > Cost of the Acquisition
The seller will be immediately paid for the acquisitions
expected benefits (if made in cash)
OR
The seller will realize a premium over the trading market
stock price (if made for stocks)

Generally Accepted Rules on M&As:
1. Pure conglomerate acquisitions do not necessarily

create new shareholder value
2. Counter cyclical acquisitions do not necessarily create
value
3. The market does not reward purely acquisition-induced
growth

Generally Accepted Rules on M&As: (cont.)
4. Related diversification can be an important means of

creating value in acquisitions
5. Acquisitions can be an important means of reaching a
critical mass, where size is an important industry factor
6. Acquisitions are a tax-efficient means of investing
excess corporate funds

There are three different valuing parties in an
acquisition:
1. The Buyer
Value = DCF of:
- Long-term operating business
- Total or partial liquidation of
the business
- Synergies from the restructuring
of both businesses
2. The Seller
Value = DCF of the best available

alternatives
3. A Potential Competing Buyer

Valuation Techniques:
- DCF: The most fundamental method of measuring value
(cash)
- Acquisition Multiples: Benchmark values based on
multiples of earnings, book value, etc.
- Premium over Market Trading Value: Percentage
premium paid to public shareholders
- Liquidation Value: Amount of cash that could be realized
if a company sells all of its assets and pays off its liabilities
in the near future
- Replacement Value: Cost of starting up a similar
company from scratch

Valuation Techniques: DCF
- Step 1.a Evaluation of historical and projections of
operating characteristics of the company, specifically:
* Unit growth rate of sales
* Rate of price increases
* Cost of goods sold as a percentage of sales
* Depreciation as a percentage of net fixed assets
* Selling, general, and administrative expenses as a percentage
of sales
* Effective tax rate
* Working capital required as a percentage of sales
* Net fixed assets required as a percentage of sales

- Step 1.b Definition of specific economic and industry
assumptions:
* Inflation
* Industry size and unit growth rate
* Market share changes within the industry
- Step 1.c Definition of scenarios by grouping varying sets

of the economic assumptions into:
* Maturity scenarios
* Growth scenarios

- Example:
Flexible Technologies Corporation: Historical Operating Records
Latest Five-Year Average
Rate of unit sales growth
7.0%
Rate of price growth
6.0%
Operating income (% of sales)
22.5%
Depreciation rate (% of net fixed assets)
12.0%
Tax rate
46.0%
Net working capital required (% of sales)
15.0%
Net fixed assets required (% of sales)
40.0%

- Example:
Flexible Technologies Corporation: Summary of Maturity Scenario
Unit sales growth

General Inflation
Rela price changes
Total price growth
Operating margin as
percentage of sales
Year 1 Year 2 Year 3

4.5%
2.5%
1.5%
4.0
4.0
4.0
(4.0)
(4.0)
(4.0)
17.3
15.0
11.0
Year 4 and
Following
1.5%
4.0
4.0
11.0
Flexible Technologies Corporation: Summary of Growth Scenario
Unit sales growth

General Inflation
Rela price changes
Total price growth
Operating margin as
percentage of sales
Year 1-8 Year 9 Year 10

7.0%
4.5%
2.5%
4.0
4.0
4.0
(4.0)
(4.0)
4.0
22.5
17.3
15.0
Year 4 and
Year 11 Following
1.5%
1.5%
4.0
4.0
(4.0)
4.0
11.0
11.0

- Step 2. Project Free Cash Flows:
Levered FCF = net income after taxes - noncash charges to income
(deferred taxes, depreciation, amort. of intangibles, etc.) - capital
expenditures - investment in net working capital (excluding cash and
short-term debt)
Example:
Flexible Technologies Corporation: Summary Calculation of Levered Free Cash Flow
Net Income
Noncash charges
Depreciation
Deferred Taxes
Less: Investment in net working capital
Less: Capital expenditures
Free Cash Flow
7,800
2,700
520
(680)
(4,700)
5,640

- Step 3. Calculate WACC (k):
Optimum Level of Debt = 20% - 50% debt to total capital
WACC (weighted average cost of debt and equity) is defined by:

k = kE(% equity) + kp(1 - t)(% debt); where:
kE
= cost of equity
kp
= cost of debt (pre-tax)
= marginal tax rate
%debt
= percentage of debt to total capital
% equity = percentage of equity to total capital

- Step 3. Calculate WACC (k):(cont.)
Cost of Debt (kp) = medium to long-term borrowing rate
Cost of Equity (kE) = rf + (rm - rf); where
rf = long-term risk free rate

rm = long-term return on the market
= systematic risk factor of the company and its industry
rm - rf = long-term real return on the market (usually
estimated between 3% and 8.5%)

- Step 4. DCF Value Calculation
Vfirm (DCF value) = Vdebt + Vequity
DCF value
= cash flow component + terminal component
= PV of unleveraged FCFs for each projection year

(discounted at k) + PV of the terminal value of the firm at the end of the
projection period (discounted at k)
Unleveraged FCF = FCF + (interest expense)(1 - tax rate)

Valuation Techniques: Acquisition Multiples
- Earnings Multiples: Use unleveraged acquisition multiples
= gross acquisition price / operating earnings;
Gross acquisition price
= price paid for equity + market value of

total debt owed by acquired company
Operating Earnings
= earnings before interest and taxes (EBIT)

= pretax earnings + interest expense
Possible Distortions:
* Non-comparable accounting principles underlying earnings
* Amount of debt associated with an acquired company
* Cyclicality of earnings

- Earnings Multiples: (cont.)
Example:
Premiums paid in selected mergers in the commercial banking industry
Dates
Acquiror
Price paid as a multiple of acquiree

Transaction Book
Market
Value
Value Earnings Value
Acquiree
South Carolina National
6/24/91 Wachovia Corp.
Corp./Wachovia Corp.
$
7/15/91 Chemical Banking Corp. Manufacturers Hanover Corp.
7/22/91 NCNB Corp.
C&S/Sovran Corp.
8/12/91 Bank America Corp.
Security Pacific Corp.
9/12/91 First America Bank Corp. Security Bancorp, Inc.
10/28/91 Comerica Inc.
Manufacturers National Corp.
10/30/91 National City Corp.
Merchants National Corp.
835.00
2136.10
4316.10
4180.30
547.00
1085.20
655.40
1.7X
0.7
1.4
1
2.8
1.3
1.9
16.2X
20
23.7
16.4
17.8
9.2
16.7
1.7X
1.2
1.5
1.5
1.8
1
1.8

- Book Value Multiples: Useful ONLY for industries where
a companys book value plays a role in determining future
profitability. Examples:
* In rate-of-return regulated industries, such as telephone, electric, and
gas utilities, where the companys future earnings are limited to a
defined return on the companys equity
* In financial institutions such as banks, insurance companies, and
security firms, where the balance sheet values of most assets and
liabilities are reasonably close to market values

- Cash Flow Multiples: Useful in industries where the
cash flow from operations (net income plus noncash
charges) is close to the free cash flow of the DCF analysis.
Example:
* Industries that undertake project-type investments: Real estate and
oil and gas industries

Valuation Techniques: Premium over Market Trading
Value
- When an acquisition candidate is publicly traded, the

buyer must pay a premium to market. The amount of the
premium will depend on the attitude of the companys
management (friendly or hostile to the acquiror) and the
regulatory climate
- Market trading values are also useful as a benchmark in
calculating the value of a privately held company or
division

Valuation Techniques: Liquidation and Replacement
Values
- Liquidation Value: amount of proceeds that could be
realized by a stockholder if a company ceased operations,
if all assets were sold at prevailing market prices, and if all
liabilities and tax obligations were satisfied
- Replacement Value: cost that would be incurred if one
tried to replicate all of the assets and liabilities of a
company by building them or purchasing them on the
market
Liquidation Value
Minimum value for a company
Replacement Value
Maximum value for a company

Valuation Techniques: Excess Assets and Liabilities
- If there are excess assets or liabilities of a company that

play no part in determining the earnings or cash flows on
which the basic valuation is made, such assets and
liabilities must be separately added to (or substracted
from) the basic value estimate

Financing an Acquisition
- Most acquisitions are made in cash
- Non cash payments are allowed when an alternative
form of consideration can achieve a superior result for
both parties
- The driving factors for non cash payments are:
* Tax Deferrals
* Accounting
* Regulatory Requirements
* Contingent Payments
* Financing Ability

Financing an Acquisition: Income Tax Aspects
- The IRC provides that an acquisition can be
accomplished without triggering income tax liability on the
part of the selling shareholder, ONLY in the following
cases:
* Reorganization through Merger
* Reorganization through Stock Purchase
* Reorganization through Asset Purchase
* Reorganization through Forward Triangular Merger
* Reorganization through Reverse Triangular Merger

Financing an Acquisition: Obtaining Tax Deferrals
1. Reorganization (merger):
Y merges into X to form XY AND at least 40-50%
of the consideration paid for Y consists of equity securities
of X
2. Reorganization (stock purchase):
X purchases at least 80% of the voting stock of Y,
using only voting stock of X in payment

Financing an Acquisition: Obtaining Tax Deferrals (cont.)
3. Reorganization (asset purchase):

Y transfers all of its assets (with or without
liabilities) to X in exchange for voting stock of X
4. Reorganization (forward triangular merger):
Y merges in to S (a subsidiary of X) and X retains
100% ownership of S. Ys former shareholders receive 40 to
50% equity securities of X to satisfy the continuity-of-interest
test

5. Reorganization (reverse triangular merger):

S merges in to Y (a subsidiary of X) and X receives
all of the voting securities of Y. Ys former shareholders
receive solely voting stock in X
- The most commonly used structures for tax-free
acquisitions are (4) and (5), the triangular mergers

What happens to the selling shareholders in a tax free
reorganization?
- If shareholders receive equity securities from the acquiror
he maintains a carry over basis in the new security
If shareholders receive
(s)he owes a capital
cash or debt
gains tax on his gain
- If shareholders receive
a mixture
(s)he may have dividend

treatment on the cash
portion
Recognition of gain or loss by shareholders will have no impact on the

target company

Subsidiary Divestitures:
- Section 355 of the IRC allows a company to distribute a
subsidiary to its stockholders in 2 ways:
1. Spin-off: the shares in the subsidiary are distributed as
a pro-rata dividend to the companys common stockholders
2. Split-off: one or more stockholders of the company
exchange their shares for shares in the subsidiary, on a nonpro rata basis

- Section 355 restrictions:
* Both, distributing company and subsidiary must have
conducted an active trade or business for 5 years
preceding the date of the transaction, and not have been
acquired during that period
* The distribution transaction must transfer at least 80%
control of the subsidiary from the company to its
stockholders
* The transaction must be supported by a non tax corporate
business purpose

- Section 355 conditions to be used as a tax saving device
for divestitures:
* The divesting company cannot arrange to sell the
subsidiary to a third party
* The distributing company receives no cash consideration
for its equity in the subsidiary and is effectively shrinking its
capitalization

Financing an Acquisition: Accounting Aspects
- There are two principal methods of accounting for

acquisitions of control of a company:
* Pooling Method Accounting: which applies exclusively to
acquisitions using the acquirors common stocks
* Purchase Method: which applies to all other forms of
acquisitions

Financing an Acquisition: Obtaining Pooling Accounting
Pooling of Interest Method of Accounting:
- Benefit: Favorable effects on the reported earnings per
share (EPS) of an acquiror when the target is being acquired
for a high multiple of its earnings
- Requirements :
* The merger must be for common stocks of the acquiror
* No subsidiaries
* Mutual independence
*Timely completion

- Requirements (cont.):
* 90% rule
* No equity changes
* Repurchases
* No voting realignments or restrictions
* No contingent earnouts
* No plan to dispose of significant assets
* No other financial arrangements

- Balance Sheet treatment: B/Ss are simply added together, line by
line, eliminating any inter-company investments which are treated as
treasury stocks
Prior to Merger Merged
Example:
A
B
A+B
Assets
Current assets
Net plant and equipment
Goodwill
Total assets
$ 200 $ 100 $ 300

200
100
300
100
50
150
$ 500 $ 250 $ 750
Liabilities and Shareholders' Equity

Current Liabilities
$ 50 $ 30 $ 80
Long-term debt
100
100
200
Deferred taxes
100
40
140
Total liabilities
$ 250 $ 170 $ 420
Common equity
250
80
330
Total liabilities and shareholders' equity $ 500 $ 250 $ 750

- Income Statement treatment: All items, down to net income,
are simply added together
- Key Statistics for Merger Analysis:
* Pro-forma EPS: Earnings are additive and the number of
shares outstanding after the merger depends on the
exchange ratio of the merger. Analyze forecasted EPS dilution
to see when it disappears and the opposite emerges
* Credit Statistics: Debt ratio and interest coverage must be
examined. As a general rule, poolings create the least
concern for the credit position of the acquiror

Pooling of Interest Accounting. Example:
Prior to Merger
A
B
Sales
Cost of Sales
Selling General and admin. Expenses
Interest Expense
Income before taxes
Income taxes
Net Income
EPS
Dividends per share
Number of shares outstanding
$
$
$
$
300
(100)
(100)
(20)
80
(32)
48
1.20
0.50
40
$
$
$
$
120
(50)
(40)
(14)
16
(6)
10
1.20
0.30
8.3
Merged
A+B
$
$
$
$
$
420
(150)
(140)
(34)
96
(38)
58
1.02
0.50
56.6
Market Assumptions
Stock price per share
P/E Ratio
Total Market Value
Dividend Yield
$
$
12 $
10
480 $
4.2%
24 $
20
200 $
1.3%
12
11.8
680
4.2%
Credit Statistics
Long-term debt capitalization (see B/S)
Interest Coverage
29%
5.0
56%
2.1
Transaction Assumptions
A acquires B
Each share of B is converted into two shares of A (exchange ratio is 2A:1B)
38%
3.8

Financing an Acquisition: Obtaining Purchase Accounting
- Basis: The investment has taken place on the part of an
acquiror, and it must be recorded at the acquirors full cost
- The cost of an investment must be allocated among the
assets acquired as follows:
* Adjust each acquiree B/S account to its fair value
* Any excess of purchase price over net fair value is
recorded as goodwill
*If the purchase price is bellow net fair value, non current
assets should be reduced proportionately
Negative
goodwill is ordinarily not recorded

Financing an Acquisition: Obtaining Purchase Accounting
- Implication for the earnings of the combined companies:
* Revaluations must be amortized against future earnings
according to the remaining life of the asset
* Goodwill must be amortized against future earnings over a
period not to exceed 40 years
* Revaluations of liabilities (bond discount or premium) must
also be amortized into earnings over an appropriate period
* In each case, it is important to ascertain the tax effect of the
particular adjustment to earnings

Purchase Method of Accounting. B/S Example:
Prior to Merger Adjust B to B as Purchase Price Combined
A
B
A and B
Fair Value Adjusted
Allocation
Assets
Current assets
Net plant and equipment
$ 200 $ 100
200
100
10a
b
50
Goodwill
Total assets
100
50
$ 500 $ 250
(50)
110
150
(100)
-
130
260
30
90
5
65
190
70
260
100
-
210
350
230
790
80
Liabilities and Shareholders' Equity

Current Liabilities
$ 50
30
Long-term debt
Pension Liability
Deferred taxes
Total liabilities
Common equity
Total liabilities and shareholders' equity
100
100
100
40
$ 250 $ 170
250
80
$ 500 $ 250
(10)
e
5
f
25
$
g
(10)
$
(70)
A acquires B
Each share of B is exchanged for $24 cash
Total transaction size is $200, which A raises by issuance of $100 in long-term debt and $100 in excess cash
Since the transaction is a stock purchase, A retains B's old tax basis in its assets
290
5
165
540
250
790

Notes on B/S:
- a Since B is on LIFO, Bs B/S understates the value of Bs inventory by
$10
- b Bs fixed assets are worth 50% more as a result of long-term inflation

effects
- c Goodwill incurred by B in its own past acquisitions has no identifiable
value and therefore is eliminated
- d Bs outstanding fixed-rate debt is worth less today because of general
interest rate rises. It therefore must be revalued at a discount
- e Bs unfunded vested pension liability is added
- f Bs deferred tax liabilities are increased by the tax effect on timing
differences arising from valuation adjustments a, b, c and e. The net
valuation adjustment is a debit of $65, which creates an additional
deferred tax provision of $25 (at a 38% tax rate)

Notes on B/S: (cont.)
- g This is a balancing adjustment reflecting the net effect on the fair value
of Bs common equity
- h Transaction price of $200 is financed by $100 in excess cash and $100

in new long-term debt
- i Goodwill incurred is aggregate price paid ($200) less fair value of net
assets acquired ($70)

Purchase Method of Accounting. Income Stat. Example:
Projected Income
Statements in
Absence of Mergers
A
Sales
Cost of Sales
Selling General and admin. Expenses
Interest Expense
Income before taxes
Income taxes
Net Income
EPS
Dividends per share
Number of shares outstanding
$
$
$
$
300
(100)
(100)
(20)
80
(32)
48
1.20
0.50
40
$
$
$
$
120
(50)
(40)
(14)
16
(6)
10
1.20
0.30
8.3
Purchase Accounting
Combined
Adjustments
A+B
(10)a
8.4b
1.6c
11.0d
$
(11.8)e
$
410.0
(158.4)
(141.6)
(45.0)
65.0
(26.2)
38.8
0.97
0.5
40.0
Market Assumptions
Stock price per share
P/E Ratio
Total Market Value
Dividend Yield
$
$
12 $
10
480 $
4.20
24
20
200
1.30
29%
5.0
56%
2.1
$
$
12.0
12.4
480.0
4.2
Credit Statistics
Long-term debt capitalization (see B/S)
Interest Coverage
A acquires B
Each share of B is exchanged for $24 cash
Total transaction size is $200, which A raises by issuance of $100 in long-term debt and $100 in excess cash
Since the transaction is a stock purchase, A retains B's old tax basis in its assets
54%
2.4

Notes on Income Statement:
- a Interest Income forgone on $100 of excess cash (at 10%)
- b Increased depreciation on Bs fixed assets $50 increase, amortized
over remaining life of six years
- c Net change in Bs goodwill amortization, assumes prior amortization of

$1.7 per year and 40-year life for amortization of new goodwill ($130)
- d Increased expense: $100 new debt, financed at 10%. In addition,

amortization of debt discount will generate another $1 of interest expense
- e Income tax effect of all purchase accounting adjustments other than

goodwill at 40%

Financing an Acquisition: Legal and Regulatory Aspects
Mergers and Consolidations:
- The most basic form of combination. In a merger, 2
corporations, A and B, combine as follows:
* The directors of corporations A and B approve an
agreement of merger, specifying:
- Terms and conditions,
- Designation of one corporation as the survivor,
- Number of shares or other consideration as a result
of the merger,
- Timing and means by which the merger is to be
carried out

Mergers and Consolidations: (cont.)
* The % of each corporations outstanding shares that must
approve the merger is 50% plus one vote, unless otherwise
specified
* The surviving corporation files a certificate of merger with
the secretary of state of Delaware
* As a result of filing, the target corporation ceases to exist
and each share of the target Corp. becomes a right to
receive the consideration provided in the agreement of
merger
* All assets and liabilities of the target Corp. becomes assets
and liabilities of the survivor

Tender Offers:
- Solicitation made broadly to shareholders of a target
company requesting tenders of shares for purchase by the
bidder. The consideration is cash or an exchange offer (less
frequent)
* Tender offers are regulated by the SEC under Williams Act.
The most important regulations are referred to:
- Prorationing
- Withdrawal
- Minimum offer period
- Amendments
- Purchases outside the offer

Asset Sales:
- The buyer agrees to buy specified assets and to assume
specified liabilities of the seller. The only assets and liabilities
transferred are those specifically agreed to in the purchase
and sale agreement
* The steps involved in a typical asset sale are:
- Buyer and seller reach agreement with respect to the sale of a
division, specifying: the price to be paid, terms and conditions,
general principal for determination of assets and liabilities to be
transferred
- Buyer and seller negotiate and execute purchase and sale
agreement. Boards of both sides approve it.

Asset Sales:(cont.)
- Buyer and seller file for antitrust clearance
- Third party waivers and consents are obtained (if necessary)
- Asset and liabilities transferred to buyer and buyer makes payment
at closing date
- Buyer and seller negotiate and execute purchase and sale
agreement. Boards of both sides approve it.
- Buyer and seller file for antitrust clearance
- Third party waivers and consents are obtained (if necessary)
- Asset and liabilities transferred to buyer and buyer makes payment
at closing date

Antitrust Review:
- The Department of Justice (DOJ) and the Federal Trade
Commission (FTC) provide public guidelines to determine
possible violations of the antitrust laws. Specifically:
* Vertical Mergers: The DOJ generally will not challenge
vertical mergers unless it creates barriers to entry, facilitates
collusion, or is designed to evade rate regulation

Antitrust Review:(Cont.)
* Conglomerate Mergers: They will ordinarily be
challenged only if they involve the elimination of a potential
entrant and:
a. the industry HHI* exceeds 1,800;
b. entry is difficult;
c. there are fewer than 3 other potential entrants; and
d. the market share of the acquired firm exceeds 5%
*Herfindahl-Hirschman Index (HHI) is used to measure industry concentration

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MERGERS AND ACQUISITIONS

M&As are financial transactions that involve a change in

M&As are a consequence of changing markets and

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

1. Pure conglomerate acquisitions do not necessarily

MERGERS AND ACQUISITIONS

4. Related diversification can be an important means of

MERGERS AND ACQUISITIONS

Value = DCF of the best available

3. A Potential Competing Buyer

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

- Step 1.c Definition of scenarios by grouping varying sets

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

Flexible Technologies Corporation: Summary of Maturity Scenario

Unit sales growth

Year 1 Year 2 Year 3

Flexible Technologies Corporation: Summary of Growth Scenario

Unit sales growth

Year 1-8 Year 9 Year 10

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

WACC (weighted average cost of debt and equity) is defined by:

= cost of debt (pre-tax)

= marginal tax rate

= percentage of debt to total capital

% equity = percentage of equity to total capital

MERGERS AND ACQUISITIONS

rf = long-term risk free rate

MERGERS AND ACQUISITIONS

= cash flow component + terminal component

= PV of unleveraged FCFs for each projection year

Unleveraged FCF = FCF + (interest expense)(1 - tax rate)

MERGERS AND ACQUISITIONS

= price paid for equity + market value of

= earnings before interest and taxes (EBIT)

MERGERS AND ACQUISITIONS

Price paid as a multiple of acquiree

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

- When an acquisition candidate is publicly traded, the

MERGERS AND ACQUISITIONS

Minimum value for a company

Maximum value for a company

MERGERS AND ACQUISITIONS

- If there are excess assets or liabilities of a company that

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS

3. Reorganization (asset purchase):

MERGERS AND ACQUISITIONS

5. Reorganization (reverse triangular merger):

MERGERS AND ACQUISITIONS

(s)he may have dividend

Recognition of gain or loss by shareholders will have no impact on the

MERGERS AND ACQUISITIONS

MERGERS AND ACQUISITIONS