Mergers & Acquisitions

FINC 446 Financial Decision Making

Dr. Olgun Fuat Sahin

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 Mergers and Acquisitions

• Vertical merger: forward or backward

integration
• Horizontal merger: expansion in a particular
business line
• Conglomerate merger: combination of
companies from unrelated business lines

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 Value Related Reasons for M&A

• Synergism
• Taxes
• Information Asymmetry
• Agency Costs

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 Synergism
• Synergism: Whole is worth more than sum of its parts
(M&A math is 2 + 2 = 5)
– Economies of scale – lower costs by combining operations
• Using excess capacity
• Spreading fixed costs over larger volume
– Economies of scope – can carry out more activities
profitably
• Producing similar products
• Backward integration – buying a supplier to reduce costs
• Forward integration – moving control one step closer to customers

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 Synergism (Continued)
– Economies of financing – larger companies can
raise money more economically
• The more money raised, the lower the issuance costs on
a per dollar raised
• Higher liquidity for the securities reducing cost of
issuance to the firm
– Risk reduction – lower unsystematic risk will
reduce expected bankruptcy costs
– Market power – larger market share allows control
over price
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 Taxes
• A merger can reduce the tax of a combined firm
because:
1. The acquirer has large cash flows with limited opportunities –
returning cash to shareholders exposes them to taxes
2. Revaluing assets of the target can create depreciation expense
for tax purposes
3. Losses of a target that have been carried forward can be used
by the combined firm
4. Alternative Minimum Tax might encourage acquisitions by
reducing overall tax payment for firms if they are combined
5. Diversification through M&A can increase debt capacity
increasing tax shield
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 Information Asymmetry

• Acquiring company posses information that is

not available to the investors
• Buying another company implies that the
acquiring firm managers have found a
“bargain”

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 Agency Costs

• M&A allows inefficient managers to be

replaced
• Activities in the takeover market curb the
agency cost

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 Management Related Reasons for
Mergers
• Reduction of Unsystematic Risk
• Takeover Risk
• Size Preference
• Hubris Hypothesis

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 Reduction of Unsystematic Risk

• Diversification at the firm level will reduce the

unsystematic risk
– Previously this was good because lower
unsystematic risk reduces expected bankruptcy
costs
– Managers also benefit form lower unsystematic
risk because lower variability in earnings increases
job security and stabilizes compensation

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 Takeover Risk

• If a company is target for a proposed

acquisition then the target can make it difficult
by acquiring another – hard to swallow
• A defensive acquisition can create a regulatory
hurdle for the original suitor as well

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 Size Preference

• Managers’ self fulfilling prophecies – bigger is

better not necessarily profitable
• Larger firm can provide more compensation
for managers

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 Hubris Hypothesis

• Hubris hypothesis suggest that acquiring firm

managers rely too much on their abilities to
identify, undertake, and manage potential
targets
• Usual outcome of such acquisitions is a
disaster admitted by divestitures

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 M&A Process

• Identify a Target
• Valuation
• Mode of Acquisition
• Mode of Payment
• Accounting of Acquisition
– Note: Regulators (Federal Trade Commission –
FTC) can block a deal or require substantial asset
sell off
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 M&A Process (Continued)
• Identify a Target:
– Based on a sound strategy that can increase
shareholders’ wealth
– Focus on “Value Related Reasons”
– Acquisitions are usually initiated by the acquiring
firm
– Sometimes a target can announce that it is for sale

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 M&A Process (Continued)
• Valuation:
• Net Cash Flow:
EBIT x (1 – tax rate)
+ depreciation and other non-cash expenses
– acquisition of new assets
+ increases in liabilities other than LTD
= Net cash flow
• Equity Residual Cash Flow:
Net Income
– preferred dividends
+ depreciation and other non-cash expenses
– acquisition of new assets
+ increases (– decreases) in liabilities
+ increases (– decreases) in preferred stocks
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= Equity residual cash flow
 M&A Process (Continued)

• Valuation:
– Should not ignore the value of strategic options and
payment terms
– In general an acquisition creates wealth for the
acquirer if: What Acquirer Gets
[Target Alone + Synergies + Other]
>= What Acquirer Gives
[Cash Paid + Stock Paid + Debt Assumed]
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 M&A Process (Continued)
• Mode of Acquisition:
– Refers to whether a proposed acquisition is friendly or hostile to
target managers
• Friendly acquisitions are approved by board of directors
of each firm
• Then shareholders vote on the proposal
• If no negotiation possibility exists then an acquirer can
proceed with a tender offer to target shareholders –
making it hostile
• Hostile takeover can be quite time consuming especially
when target managers fight against the tender offer
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 M&A Process (Continued)

• Mode of Payment:
– How an acquisition is paid for: cash, stock or
mixed
• If the stock is believed to be undervalued, then
stock should not be used for payment
• If the stock is overvalued then the stock
payment should/can be used

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 Takeover Defense
• Golden parachute
– A contract designed to give executives substantial
compensation if they are dismissed following a
takeover
• Poison pills, flip-over rights allowing holders
to receive stock in the acquirer if the bidder
acquires 100% of the target
• Poison pills, flip-in rights allowing holders to
receive stock in the target
– It is effective against raiders who seek to acquire
controlling interest
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 Takeover Defense (Continued)

• Poison puts
– Bond issues that become due if unfriendly
takeover occurs
• Greenmail
– Managers of target buys shares purchased by
acquirer at a substantial premium
• White knight
– A third company acquiring the target with friendly
terms
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 Accounting Method

• There used to be two methods: Pooling of

Interest and Purchase method for acquisitions
• Pooling of Interest:
– It can be used if payment is made in the form of
acquirer’s stock
– Balance sheet and income statement of the
combined company are generated by adding up
items

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 Accounting Method (Continued)
• Purchase method:
– Balance sheet of the combined entity is constructed as follows:
If the price paid is same as the net asset value (book value –
total liabilities), balance sheet of the combined company is
generated by adding up items
– If the price paid is less than the net asset value, the assets are
written down
– If the price paid is more than the net asset value, the assets are
appraised. If the price is still more than appraised value of net
assets, the difference is an asset called goodwill
– The income statement reflect the depreciation expenses adjusted
for the revaluation

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 Accounting for Goodwill
• The Financial Accounting Standards Board (FASB)
issued two statements changing all that:
• FASB Statement No. 141 Business Combinations
– Requires the purchase method of accounting be used for all
business combinations initiated after June 30, 2001
• FASB Statement No. 142 Goodwill and Other Intangible
Assets
– Changes the accounting for goodwill from an amortization
method to an impairment-only approach
– “Goodwill will be tested for impairment at least annually using
a two-step process that begins with an estimation of the fair
value of a reporting unit. The first step is a screen for potential
impairment, and the second step measures the amount of
impairment, if any.”
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 Target and Acquirer Performance
around Announcement
• Dodd (1980), “Merger proposals, management discretion
and stockholder wealth,” Journal of Financial Economics,
Volume 8, Issue 2, June 1980, Pages 105-137
– 151 targets and 126 bidders over 1970-1977
Bidders Targets
2-day AR * -1.09% 13.41%
Successful Sample Size 60 71
T-statistics -3.0 23.8
2-day AR -1.24% 12.73
Unsuccessful Sample Size 66 80
T-statistics -2.6 19.1
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* AR is Abnormal Return = Actual – Expected. Reported AR is average of firm ARs.
 Target and Acquirer Performance
around Announcement (Continued)
• Bradley, Desai & Kim (1988), “Synergistic gains from
corporate acquisitions and their division between the
stockholders of target and acquiring firms”, Journal of
Financial Economics, Volume 21, Issue 1, May 1988,
Pages 3-40
– 3-day announcement abnormal return for 236 successful tender
offers over 1963-1984

Sample Size Bidders Targets

Total Sample 236 0.00% 21.6%
Single Bidders 163 0.65% 22.0%
Multiple Bidders 73 -1.45% 20.8%
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 Target and Acquirer Performance
around Announcement (Continued)
• Bradley, Desai & Kim (1983), “The gains to bidding
firms from merger,” Journal of Financial Economics,
Volume 11, Issues 1-4, April 1983, Pages 121-139
– 353 targets: 241 successful, 112 unsuccessful
– 94 unsuccessful bidders
– 1983-1980
Sample Size Targets
Unsuccessful Targets 112 35.6%
Subsequently Taken Over 86 39.1%
Not Subsequently Taken Over 26 23.9%
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Acquirer Performance in the Long-Run

• Long Run Abnormal Return = Long-Run Actual

Return – Long-Run Expected Return
• Long-Run Event Studies are very sensitive to “Joint
Hypothesis Problem”
– They test two hypotheses
• There is no abnormal performance after acquisitions – Null
• The method of risk adjustment (estimation of expected return) is
accurate. This is very important since we do not have an asset
pricing model that can explain security returns well

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Acquirer Performance in the Long-Run
(Continued)
Study Sample Expected Returns AR Calculation Major Results
Franks, Harris 399 acquisitions, (1) CRSP equal-weighted Jensen’s α in event- Jensen’s α:
and Titman January 1975- market index time and calendar-time Average Abnormal Returns are (1) -0.2, (2) 0.29,
(1991) December 1984 (2) CRSP value-weighted portfolios (3) -0.11, and (4) -0.11 per month over 36 months.
market index (1) and (2) are significant.
(3) Ten-factor model Calendar-time portfolios:
(4) Eight portfolio (2) 0.37 per month and significant
benchmark (4) does not detect any abnormal performance with
sub-samples as well
Agrawal Jaffe, 1,164 acquisitions, (1) Beta and size CAAR, starting with CAAR for (1) is -10.26 for (+1, +60) and
and Mandelker January 1955- (2) Returns Across Time and AD significant. CAAR for model (2) is similar. No
(1992) December 1987 Securities (RATS) with size abnormal performance during Franks, Harris and
adjustment Titman (1991) study period
Loderer and 1,298 acquisitions, Similar to RATS CAAR, starting with Abnormal Returns are negative and significant over
Martin (1992) 1955-1986 effective date (ED) 3 years after acquisitions but insignificant over 5
years
Loughran and 947 acquisitions, Matching firm based on size Buy-and-Hold BHAR over five years is -6.5 and insignificant.
Vijh (1997) 1970-1989 and book-to-market Abnormal Return Cash BHAR is 18.5 and insignificant and Equity
(BHAR) starting with BHAR is -25 and significant
ED
Rau and 3,517 acquisitions, Size and book-to-market CAAR, starting with CAARs for mergers and tender offers are -4.04 and
Vermaelen January 1980- matching portfolios CD 8.85, respectively. Both figures are statistically
(1998) December 1991 significant
Mitchell and 2,193 acquisitions, Size and book-to-market BHAR and Calendar- BHAR is zero for all acquisitions after adjusting for
Stafford (2000) 1958-1993 matching portfolios Time Abnormal cross-sectional dependence, CTAR is negative and
Return (CTAR) significant for equity financed acquisitions.

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