Lectures # 9 & 10

The International Market for

Corporate Control
Principles of International Finance - Course 30151
Gimede Gigante
 AGENDA

Firm growth & value creation

– Definition of M&A

– Takeover Methods

– A Classification Scheme of M&A

– Sensible reasons for mergers

– Dubious reasons for mergers

– Valuation of a Target: Main Evidences from M&A Transactions

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 AGENDA

Firm growth & value creation

– Definition of M&A

– Takeover Methods

– A Classification Scheme of M&A

– Sensible reasons for mergers

– Dubious reasons for mergers

– Valuation of a Target: Main Evidences from M&A Transactions

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 How to Grow?

Growth Strategies

Growth

Internal / Organic External

 Increase production capacity  M&A Transactions

 Expand distribution platforms ―Mergers
 Innovation / Product mix ―Acquisitions
 Commercial Strategy /  ―JVs
Marketing

 M&A is an alternative form of investment to fuel the growth of a company with respect to organic /
internal development. Selection between the two alternatives should be based on cost benefit analysis
and execution risks assessment (“Make or Buy” decisions).

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 What is M&A?
M&A is a Broad Term Encompassing Various Types of Transactions

M&A can be considered any process where the ultimate beneficial ownership, and the 
respective control of a firm, are transferred from a subject (or a group of subjects) to another
Acquiring Company Acquired Company

Acquires Control Loses Control

Bidder Target Seller(s)

Consideration

Various Dimensions of the M&A Transactions 

Objectives Consideration Financing Status of the Target

 Strategic: Bidder is a   Statutory Merger: Target is   Cash: Bidder pays   Debt Financing:  Private: Target is sold
corporate which executes merged into Bidder and Seller(s) in cash Consideration is financed  through a private
the M&A transaction to ceases to exists through cash on balance transaction, between
 Equity: Bidder pays
accomplish its own  Acquisition of Target: Target sheet or raising debt Bidder and Seller(s)
corporate objectives Seller(s) with its own
continues to exists as a   Public (Tender Offer):
shares, in exchange of  Equity Financing:
subsidiary of the bidder A public offer to buy
 Financial: Bidder is a  the shares of the Consideration is financed 
Financial Investor (PEs,  Acquisition of Assets: Target raising equity (e.g. Right shares is made by the
HFs, the management Target’s Assets transferred Issue) Bidder directly to Target’s
etc.) looking for a  to the Bidder  Mixed: Bidder pays shareholders
targeted financial return Seller(s) with a mix of
cash and of its own
shares

• An M&A transaction can be shaped in various forms, with different characteristics, depending on the combination of
the above options

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Strategic Buyers vs Financial Buyers
 The process of an Acquisition

Friendly Acquisition ‐‐ The managers of the target firm welcome 

the acquisition and, in some cases, seek it out
Hostile Acquisition ‐‐ The target firm’s management does not want
to be acquired. The acquiring firm offers a price higher than the
target firm’s market price prior to the acquisition and invites
stockholders in the target firm to tender their shares for the price

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The process of an Acquisition
 The process of an Acquisition

Method of Payments:

Cash offering -- It may be cash from existing acquirer

balances or from a debt issue.
Securities offering ‐‐ Target s.hareholders receive shares
of common stock, preferred stock, or debt of the 
acquirer. The exchange ratio determines the number of 
securities received in exchange for a share of target
stock.
 AGENDA

Firm growth & value creation

– Definition of M&A

– Takeover Methods

– A Classification Scheme of M&A

– Sensible reasons for mergers

– Dubious reasons for mergers

– Valuation of a Target: Main Evidences from M&A Transactions

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 A Classification Scheme of M&A

• Horizontal Merger:
– combinations of two (2) firms in the same line of business:

• ex. Bank of America’s acquisition of Merrill Lynch;

• Adidas and Reebok

• Vertical Merger:
– between companies operating in different stages of production:

• ex. Tele Atlas bought by Tom Tom;

• BskyB and Amstard

• Conglomerate Merger:
– between companies operating in unrelated businesses;

• ex. AOL’s – Time Warner;

– much less popular now

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 AGENDA

Firm growth & value creation

– Definition of M&A

– Takeover Methods

– A Classification Scheme of M&A

– Sensible reasons for mergers

– Dubious reasons for mergers

– Valuation of a Target: Main Evidences from M&A Transactions

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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;
– natural goal of horizontal mergers;
• Economies of vertical integration:
– occurs with a merger between a firm and one of its suppliers/customers;
– control over suppliers «may» reduce costs and increase efficiency;
– eases the firm’s coordination and administration;
– over‐integration can cause the opposite effect;
• Complementary resources:
– merging may results in each firm filling in the «missing pieces» of their firm with pieces 
from the other firm

– each firm has what the other one needs;

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 Sensible reasons for mergers

• Surplus funds:
– if the firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be 
the best use of funds;

– firm with a cash surplus and a shortage of profitable investment opportunities often turn to cash‐ 
financed mergers as a way of redeploying their capital;

• Eliminating inefficiencies:
– cost cuts generate increases in sales and earnings;

– firms with unexploited opportunities to cut costs/increase sales and earnings are natural candidates
for acquisitions by other firms with better management;

• Industry consolidation:
– industries with too many firms and too much capacity usually trigger waves of M&A;

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 AGENDA

Firm growth & value creation

– Definition of M&A

– Takeover Methods

– A Classification Scheme of M&A

– Sensible reasons for mergers

– Dubious reasons for mergers

– Valuation of a Target: Main Evidences from M&A Transactions

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 Dubious reasons for mergers

• Diversification:
– easier/cheaper for stockholders than for the firm itself;
– investors should not pay a premium for diversification since they can do it themselves;
– value additivity principle;

• 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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 AGENDA

Firm growth & value creation

– Definition of M&A

– Takeover Methods

– A Classification Scheme of M&A

– Sensible reasons for mergers

– Dubious reasons for mergers

– Valuation of a Target: Main Evidences from M&A Transactions

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 Valuation of a Target: Main Evidences from 
M&A Transactions
• Firms that grow through acquisitions have generally had far more trouble creating value than firms 
that grow through internal investments

• In general, acquiring firms tend to:

1. Pay too much for target firms
2. Over estimate the value of “synergy” and “control”
3. Have a difficult time delivering the promised benefits
• Worse still, there seems to be very little learning built into the process. The same mistakes are
made over and over again, often by the same firms with the same advisors

Conclusion:
There is something structurally wrong
How to Value a Target: Valuation Methods in Context

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How to Value a Target: Valuation 
Methods in Context

a. Main Valuations in M&A Context

b. How to value Synergies
c. How to value Premium for the Control
 Valuation of a Target: Main Evidences from 
M&A Transactions
• Objective of the Bidder approaching the valuation exercise is to define a fair value
for the target company
• Objective of the target is to define a price at which it is willing to sell

• Valuation is an intellectual exercise, whose role is the support to the negotiations 

around the price of a M&A transaction
 M&A prices may differ from theoretical stand‐alone valuations due to certain
factors affecting bid‐ask spread dynamics
– Competitive pressure
– Synergies
– Management change effects / Restructuring plans

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 DCF Analysis – Key Consideration

Methodology Description Main Applications

 Intrinsic value of a business' cash   Project with finite life (10y versus 5y)
flows on a risk adjusted basis  Stable, low growth, predictable and 
 Takes into account time value of  not cyclical business/cash flows
money

Typical Uses Challenges

 How much could buyer pay?
 How much should seller want?
 Allows us to perform "what if?" 
scenario analysis
 High growth or start‐up firms and 
other situations where majority of 
value lies outside projection period 
and not yet in steady state
 Troubled or loss making firms

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 Trading Multiples
Generalist Multiples

Wideness of
Multiple Pros Cons Application
Price/Earnings  Traditional, more intuitive, linked to actual return × Earnings can be very volatile
for shareholders × Dependent on accounting standards
 Truly represents equity investor point of view × Dependent on capital structure 
× Earnings can be negative

EV/EBITDA  Takes into account × Does not consider below EBITDA items 

profitability of the company which may drain cash and may be 
 Not subject to differences in non‐cash recurring (e.g. Taxes)
depreciation accounting (vs. EBIT) × Exposed to accounting policy decisions
 Not subject to capital structure (e.g. capitalized costs)
 Proxy cash generation (before working capital 
dynamics)

EV/Sales  Sales cannot be negative, applicable in case of × Does not take into account profitability
negative profitability × Does not take into account capital 
(only in certain 
 Comparable across all firms structure
sectors)

Growth   Usually applied on Earnings or EBITDA × Used only to a certain extent, based on
Adjusted  Proxy for DCF unusual L‐T growth expectations
Multiples  Allows to price growth expected into multiple
levels

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 Transaction Multiples

Definition  A summary of acquisition transactions in a particular industry that helps 

ascertain the value of a business in the market
(Deal comparison)
 Based on public information available on announcement date
 Similar to the Trading Multiples method, however the two methods differ 
significantly

Goals
Value a Business Ascertain Sector Conditions

 Determine relevant sector  Determine demand for business 

valuation metrics types
 Identify multiples paid in similar   Identify acquisitive companies in a 
transactions sector
 Facilitate discussion of specific   Facilitate discussion of industry 
deals/multiples trends

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How to Value a Target: Valuation 
Methods in Context

a. Main Valuations in M&A Context

b. How to value Synergies
c. How to value Premium for the 
Control
 The value of Synergies

What is synergy?
Synergy is the additional value that is generated by combining two firms, 
creating opportunities that would not been available to these firms operating 
independently:
 Operating synergies
– affect the operations of the combined firm and include economies of
scale, increasing pricing power and higher growth potential. They 
generally show up as higher expected cash flows
 Financial synergies
– are more focused and include tax benefits, diversification, a higher
debt capacity and uses for excess cash. They sometimes show up as 
higher cash flows and sometimes take the form of lower discount 
rates

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 The value of Synergies

Valuing Operating Synergies

 (a) What form is the synergy expected to take?

– Will it reduce costs as a percentage of sales and increase profit 
margins (as is the case when there are economies of scale)? Will it 
increase future growth (as is the case when there is increased market 
power)?

 (b) When can the synergy be reasonably expected to start affecting 

cashflows?
– Will the gains from synergy show up instantaneously after the 
takeover? If it will take time, when can the gains be expected to start 
showing up?

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 The value of Synergies

Financial Synergy
 1. Tax Benefits
– can arise either from the acquisition taking advantage of tax laws to 
write up the target company’s assets or from the use of net operating 
losses to shelter income

 2. Debt Capacity
– It can increase, because when two firms combine, their earnings and 
cash flows may become more stable and predictable. This, in turn, 
allows them to borrow more than they could have as individual 
entities, which creates a tax benefit for the combined firm. This tax 
benefit usually manifests itself as a lower cost of capital for the 
combined firm

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 How WACC curves may shift

Stand alone limits
WACC

WACC
Debt/  Debt/ 
Effects of  Debt + Equity
Optimum Debt + Equity
coinsurance

• Investors may be able to optimize WACC on their own, through homemade leverage…

• … but the combination of buyer + target does not always trigger positive shifts in
WACC!!

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 The value of Synergies

• 3. Excess cash (or cash slack)

– A company with limited project opportunities and a firm with high‐ 
return projects (and limited cash) can yield a payoff in terms of higher 
value for the combined firm. This synergy is likely to show up most 
often when large firms acquire smaller firms, or when publicly traded 
firms acquire private businesses

With financial synergies, the payoff can take the 

form of either higher cash flows or a lower cost 
of capital (discount rate) or both

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 The value of Synergies

A procedure for valuing synergy

(1)the firms involved in the merger are valued independently, by discounting 
expected cash flows to each firm at the weighted average cost of capital for
that firm
(2)the value of the combined firm, with no synergy, is obtained by adding the 
values obtained for each firm in the first step
(3)The effects of synergy are built into expected growth rates and cashflows, 
and the combined firm is re‐valued with synergy

Value of Synergy =
Value of the combined firm, with synergy –
Value of the combined firm, without synergy

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How to Value a Target: Valuation 
Methods in Context

a. Main Valuations in M&A Context

b. How to value Synergies
c. How to value Premium for the 
Control
 The Value of Control

The value of control should be inversely proportional to the 

perceived quality of that management and its capacity to
maximize firm value

• Value of control will be much greater for a poorly managed

firm that operates at below optimum capacity than it is for a
well managed firm
» Value of Control = Value of firm, with
restructuring ‐ Value of firm, without
restructuring

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 Common Errors in Valuing Synergy

a. Target Firm Stockholders

 Acquiring firms should follow a simple rule when it comes to

value. They should not render unto target firm stockholders
premiums for items or strengths that these stockholders had
no role in creating. A fair sharing of synergy should leave the 
acquiring firm’s stockholders with at least some of the
incremental value from synergy

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 Common Errors in Valuing Synergy

b. Mixing Control and Synergy

– Synergy requires two entities (firms, businesses, projects) for its 
existence and is created by combining the two entities.
– Control, on the other hand, resides entirely in the target firm and does 
not require an analysis of the acquiring firm (or its valuation)
 If both control and synergy are motives in the same acquisition, it is best 
to assess their values separately. In fact, the value of control should be 
estimated first by valuing the target firm twice, once on a status quo basis 
(with existing management) and once with the changes that are intended 
in how the company is run.
 Once the value of control has been estimated, the value of synergies can 
be estimated

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 Common Errors in Valuing Synergy

c. Wrong Discount Rate

 Cash Flows generated by synergy accrue to the combined firm 
and not to the target or acquiring firm separately. We should be
using the combined firm’s cost of equity and/or capital to
discount these cash flows. In many acquisitions, the cash flows
from synergy are discounted at either the acquiring firm or the
target firm’s cost of equity/capital
 Analysts often Discount Tax Savings that arise as a
consequence of acquisitions at the riskless rate. Cash flows
generated by synergy are never riskless and using the riskless 
rate to discount cash flows is inappropriate

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 CONCLUSIONS:
M&A performance
Do M&As create or destroy value?
– Abnormal returns upon announcement are on average
positive for the target but negative for the bidder
• But they depend on the method of payment, the listing status,
etc..
– Bidders undeperfom in the long‐run
M&A is a complex process, its success depends on
many factors:
– Bidder experience; target selection; discipline in execution
– Value and likelihood of the synergies
– Integration plan
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 Things to Remember…

• M&A’s Activities

– takeover methods
– types of merger
– motives: sources of value added
– dubious motives: don’t be tempted
– A consistent valuation of the Target is crucial

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