Chapter 17 Mergers and Acquisitions Mergers and Acquisitions Merger – a combination of two or more businesses under one ownership Acquisition or Takeover - one firm acquires the stock of another – Acquired firm is the target Consolidation - combining firms dissolve forming a new legal entity Figure 17-1 Basic Business Combinations Mergers and Acquisitions Relationships – Consolidation implies the firms combined willingly – Acquisition can be a friendly or hostile takeover Stockholders – Must be willing to give up their shares for the offered price – Approval from majority necessary for acquisition to be successful Mergers and Acquisitions Friendly Procedure – – – Target firm's management approves and cooperates with acquiring company Negotiation occurs until agreement is reached Unfriendly Procedure – – Target firm's management resists, takes defensive measures to stop takeover Acquiring firm makes a tender offer to the target's shareholders Proposal submitted for stockholder vote Why Unfriendly Mergers are Unfriendly A target's management may resist a takeover because: – Acquiring firm offered too low a price for the stock – Target’s management often loses jobs, power, and influence Economic Classification of Business Combinations Vertical Merger – Acquiring suppliers of customers Horizontal Merger – Merging firms are competitors Congeneric Merger – Firms are in related but not competing businesses Conglomerate Merger – Firms are in entirely different fields A Further Classification Strategic Merger – Merger is undertaken to enhance the acquirer’s business position Financial Merger – Merger is undertaken to make money from the merger process Role of Investment Banks Help companies issue securities Instrumental in acting as advisors to acquiring companies Assist in establishing a value for target Help acquiring firm raise money for acquisition Advise reluctant targets on defensive measures The Antitrust Laws U.S is committed to a competitive economy Antitrust laws (enacted 1890 - 1930s) prohibit certain activities that can reduce competitive nature of the economy Mergers have potential to reduce competition 10 Divestitures A company decides to get rid of a particular business operation – Reasons for divestitures A firm needs cash A division may not fit strategically into the firm's long-term plans Poor performance 38 Divestitures Methods of Divesting Companies – Sale for cash and/or securities – Spin-off —creates a new company owned by the same stockholders, can trade separately – Liquidation —the divested business is closed down and its assets sold 39 Failure and Insolvency Economic failure —a firm is unable to provide adequate return to its stockholders Commercial failure —a business cannot pay its debts (insolvent) A business can be an economic failure without being a commercial failure 40 Bankruptcy Concept and Objectives Bankruptcy – protects a failing firm from creditors until a resolution is reached to close or continue it Bankruptcy court protects a firm from its creditors and determines whether it should shut down or continue – Liquidation – Reorganization 41 Bankruptcy Procedures—Reorganization, Restructuring, Liquidation Reorganize Liquidate Insolvent company perceived as Insolvent company deemed recoverable will reorganize unrecoverable will liquidate Debt will be restructured and a Assets will be sold under the court's plan developed to pay creditors as fairly as possible supervision, with proceeds to pay creditors according to priority 42 Bankruptcy Procedures—Reorganization, Restructuring, Liquidation Bankruptcy petition can be initiated – voluntarily by insolvent company or – involuntarily by its creditors A firm in bankruptcy is usually allowed to continue operations – Trustee oversees the firm’s operations to protect the interests of its creditors 43 Reorganization A plan under which an insolvent firm continues to operate while attempting to pay off its debts Reorganization plans are judged on fairness and feasibility – – Fairness—claims are satisfied based on priorities Feasibility—likelihood the plan will actually work Plan must be approved by the bankruptcy court, firm's creditors and stockholders 44 Debt Restructuring Involves concessions that lower an insolvent firm’s payments so it can continue to operate Can be accomplished in two ways: – Extension – Composition Creditors have an incentive to compromise because if the firm fails they are likely to receive even less 45 Debt Restructuring Debt-to-equity conversions are a common method of restructuring debt – Creditors give up debt claims in return for stock in the company – Equity may be worth more in the long run than the debt given up 46 Concept Connection Example 17-4 Debt Restructuring in Bankruptcy Adcock has 50,000 shares of common stock outstanding at a book value of $40, pays 10% interest on its debt, and is in the following financial situation Income and Cash Flow EBIT Interest Capital $200 Debt $6,000 600 Equity 2,000 EBT ($400) Tax - Total capital $8,000 Notice that although the company has positive EBIT, it doesn't earn enough to pay its interest let alone repay principal on Net Income ($400) schedule Without help of some kind it will fail shortly Devise a composition involving a debt for equity conversion that will keep Depreciation Principal Repayment Cash flows 200 the firm afloat (100) ($300) 47 Concept Connection Example 17-4 Debt Restructuring in Bankruptcy Suppose creditors are willing to convert $3 million in debt to equity at the $40 book value Requires issuing 75,000 new shares, resulting in the following financial situation Income and Cash Flow EBIT Interest Capital $200 Debt $3,000 300 Equity 5,000 EBT ($100) Tax - Net Income ($100) Total capital $8,000 Notice that the company now has a slightly positive cash flow and can at least theoretically continue in business indefinitely However, creditors now own a Depreciation 200 Principal Repayment (50) Cash flows controlling interest in the firm ($50) 48 Liquidation Closing a troubled firm and selling its assets Trustee attempts to recover any unauthorized transfers out of the firm Trustee supervises the sale of the assets, pools and distributes the funds 49 Liquidation Claimants include – Vendors - who sold to the firm on credit – Employees – who are owed wages – Customers - deposits for merchandise – Government - owed taxes – Lawyers and the court – Stockholders - receive whatever is left 50 Distribution Priorities Bankruptcy code contains priorities for the distribution of assets among claimants Priority code payoffs of unsecured claimants: – – – – – – – – – Administrative expenses of the bankruptcy proceedings Certain business expenses incurred after the bankruptcy petition is filed Certain unpaid wages Certain unpaid contributions to employee benefit plans Certain customer deposits Unpaid taxes Unsecured creditors Preferred stockholders Common stockholders 51 Bankruptcy Code Chapters Chapter – Liquidation Chapter 11 – Reorganization Notice that Bankruptcy is a Federal court procedure, not state – Although some state laws apply 52 [...]... Scale Guaranteed Sources and Markets Acquiring Assets Cheaply Tax Losses Ego and Empire 12 Tax Losses Rich Inc EBT Tax (35%) Net Income Poor Inc Merged $2,000 ($1,000) $1,000 700 -0- 350 $1,400 ($1,000) $650 Combined Businesses pay less total tax But IRS will not recognize if sole purpose is to reduce tax 13 Holding Companies Corporation that owns other corporations – – Companies owned are subsidiaries... Private equity groups bought companies for financial reasons – Ended with the financial crisis of 2008 17 Mergers since the 1980s Mergers since the 1980s are characterized by: Large Size Global Horizontal mergers and antitrust Easy financing Hostility Raiders Defenses Advisors Megamergers since the 1980s Companies Year Industry $ Size Citicorp and Travelers 1988 Financial Services $140 billion MCI and... 1897-1904 – Horizontal mergers transformed the U.S into a nation of industrial giants, with some monopolies Wave 2: The Roaring Twenties, 1916-1929 – – Began with World War I and ended with the stock market crash of 1929 Horizontal mergers led to oligopolies 15 The History of Merger Activity in the U.S Wave 3: The Swinging Sixties, 1965-1969 – – Conglomerate mergers - unrelated fields Stock market driven An... equity transaction Use target’s estimated equity rate (CAPM) Value to the Acquirer is the PV of estimated cash flows from target – Maximum value makes NPV=0 if viewed in capital budgeting terms Payment for target’s stock is C0 – the initial outlay Maximum Per-share Price is Maximum PV ÷ number shares 23 Merger Analysis and the Price Premium Price Premium – The price offered to target shareholders must be... and has helped firms raise cash to finance many mergers 31 Paying for the Acquisition The Junk Bond Market Junk bonds are low quality (risky) bonds that pay high yields Prior to 1980s small, risky companies could not borrow via bonds – Investment bankers pooled risky bonds into funds creating the junk bond market – The idea collapsed in the late 1980s Since 1990’s, high yield debt has reemerged 32 The... firm more leveraged – It can be argued that this increases its value See Chapter 14 on capital structure and leverage - The Effect of Paying Too Much – An acquiring firm that pays too much for a target transfers value from its shareholders to the target’s shareholders 33 Defensive Tactics: After a Takeover is Underway Defensive Tactics are things targets do to keep from being acquired Tactics After... Tactics: In Anticipation of a Takeover Tactics in Anticipation of a Takeover – Staggered Election of Directors – Approval by a supermajority – Poison pills – Golden parachutes – Accelerated debt – Share rights plans 35 Leveraged Buyouts (LBOs) Investors take a company private by buying all of its stock largely using borrowed money – Then attempts to work down the debt Tends to be risky due to high debt... Terminal Values (TVs) TVs can overwhelm detailed forecast – Especially an infinite stream of income TV is valued as the PV of a perpetuity starting at end of detailed forecast – TVs are favored by people who want the acquisition for non financial reasons – It’s up to Finance (CFO) to keep the assumptions reasonable Terminal Value assumptions often lead to overpaying for an acquisition Paying for the...The Reasons Behind Mergers Synergies – Combined performance is expected to be better than the sum of the separate performances – Usually cost saving or marketing opportunities Growth – External growth through acquisition is faster than internal growth Diversification to Reduce Risk – Collection of diverse businesses less risky than a single line – Variations... 1970s 1974 INCO acquires ESB assisted by respected investment bank Morgan Stanley After that hostile takeovers became acceptable 16 The History of Merger Activity in the U.S Wave 4: Megamergers, 1981 – 1990 – Very large firms, often industry leaders, merge Wave 5: Globalization, 1992 – 2000 – Began after 1991 – 1992 recession – Large number of international mergers – Ended with September 11, 2001 Wave