Corporate Finance reading material:

Mergers & Acquisitions

EMAIL:MARTA.DEGLINNOCENTI@UNIMI.IT
Learning Objectives
• Explain the motivation of M&A.
• Estimate the gains and costs of M&A.
• Describe ways that companies change their
ownership or management.
•Describe takeover defences.

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Summary of M&A

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 Types of M&A
Horizontal Merger
◦ A merger between two firms in the same line of business (former
competitors), i.e. Bank of America and Merrill Lynch.
Vertical Merger
◦ A merger between companies at different stages of production,
i.e. Nokia Handset and Microsoft.
Conglomerate Merger
◦ A merger between companies in unrelated lines of business, i.e.
Tata group and Eight O’Clock Coffee.

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 Examples of M&A
Payment
Industry Acquirer Target
($ in billions)
Vodafone’s holding of
Telecom Verizon 130
Verizon Wireless (UK)

Mining Glencore (Swiss/UK) Xstrata (Swiss/UK) 49

Berkshire Hathaway
Food HJ Heinz 23
and 3G Partners

IT Facebook WhatsApp 19

Software Microsoft Skype 9

Intercontinental
Securities exchanges NYSE Euronext 8
Exchange

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 Motivations of M&A
Economies of scale
◦ Managers always believe their firms would be more competitive
if only it were just a little bigger.
◦ With economies of scale, a larger firm may be able to reduce its
per unit cost.
Combining complementary resources.
◦ Providing the missing ingredients necessary for the firm’s
success.
A small firm may have a valuable patent, but lack the engineering and
sales organization necessary to produce and market it on a large scale. It
could be acquired by a larger firm with those capacities already in place.

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 Motivations of M&A (cont’d)
Economies of vertical integration
◦ Expanding back toward the raw material or end consumer.
◦ Control over suppliers “may” reduce costs.
◦ Over-integration can cause the opposite effect.
Pre-integration (less Post-integration
efficient) (more efficient)
Company
Company

S
S
S
S
S

S S S

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 Motivations of M&A (cont’d)
Economies of vertical integration
◦ Expanding back toward the raw material or end consumer.
◦ Control over suppliers “may” reduce costs.
◦ Over-integration can cause the opposite effect.
Mergers as a use for surplus funds
◦ Agency problem / avoid being a target.
Eliminating governance inefficiencies
◦ Better management: Mergers vs Acquisitions
Industry consolidation
◦ Improving efficiency by merging within industries containing too
many firms and too much capacity.

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 Dubious Reasons for Mergers
Diversification
◦ Cost of diversification: companies vs shareholders.
◦ Investors should not pay a premium for diversification since they can
do it themselves.
The Bootstrap game: Merger with no economic benefits.

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 The Bootstrap game
Acquiring Firm has high P/E ratio.

Selling firm has low P/E ratio.

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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 The Form of the Acquisition
Merger
◦ When the acquiring firm buys all the assets and all the liabilities of the
other firm and combines them into one firm.
◦ Must have the approval of at least 50% of the shareholders of each
firm.
Tender Offer
◦ The acquiring firm buys the stocks of the target firm. The target may
continue to exist.
Asset Purchase
◦ When the acquiring firm buys only the assets of the target. The target
continues to exist as firm with cash instead of assets.

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 Evaluating M&A
• Is there an overall economic gain to the merger?
• Do the terms of the merger make the company and its
shareholders better off?

Synergy?
PV ( A + B )  PV ( A) + PV ( B )

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Evaluating M&A: Economic gain

Increased earnings:
$172 − ($150 + $20)
+ | $132 − ($118 + $16) |= $4 million
Economic gain=PV(increased earnings)
increased earnings 4
= = = $20 million
cost of capital 0.20

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 Evaluating M&A
Cash Purchase Exchange of shares
(in mil.) (in mil.)
Original value of Cislunar $480
+ Original value of Targetco $40
+ Economic gain from merger $20
- Cash paid to Targetco shareholders
($47.5)
(assuming $19/share)
= Value of Cislunar after merger $492.5
Cislunar shares outstanding
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postmerger

Cislunar price per share postmerger $49.25

NPV=economic gain - cost $20-$7.5=$12.5

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 Evaluating M&A
Cash Purchase Exchange of shares
(in mil.) (in mil.)
Original value of Cislunar $480 $480
+ Original value of Targetco $40 $40
+ Economic gain from merger $20 $20
- Cash paid to Targetco shareholders
($47.5) 0
(assuming $19/share)
= Value of Cislunar after merger $492.5 $540
Cislunar shares outstanding
10 10+(2.5/3)=10.83
postmerger (1 to 3 exchange)

Cislunar price per share postmerger $49.25 $49.85

NPV=economic gain - cost $20-$7.5=$12.5 $20-$1.54=$18.46

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 The Market for Corporate Control
• Proxy Contests
• Takeovers
• Leveraged Buyouts
• Divestures, Spin-Offs or Carve-Outs

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 Proxy Contests
Proxy: The right to vote another shareholder’s shares.
Takeover attempt in which outsiders compete with management
for shareholders’ votes.
Institutional shareholders, i.e. mutual fund, hedge fund, pension
fund etc., might be more aggressive and have large bargaining
power.
“Corporate raider” Carl Icahn
In 2008: Proxy fight to gain seat on the board of Yahoo and ousting of Jerry
Yang from his position as CEO to allow Microsoft to purchase the web
company. Also in 2008: Failed attempt to gain seat on the board of
Motorola (less than 7% votes).

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 Takeovers
Tender Offer: a direct offer of purchase to current shareholders, without
consulting with management.
A "hostile takeover" allows a bidder to take over a target company whose
management is unwilling to agree to a merger or takeover.
Takeover Defensive Tactics
◦ White Knight: company or individual that act as a preferred acquirer
when target is being taken over by force from undesirable company.
◦ Shark Repellent: Amendment to companies’ charter made to forestall
takeover attempts.
◦ Poison Pill: A strategy used by corporations to discourage hostile
takeovers by making its stock less attractive to the acquirer.
◦ Golden Parachute, Scorched-earth defence etc.
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Takeovers (cont’d)
Examples: Oracle vs PeopleSoft
PeopleSoft’s Poison Pill
1. Shares offered to the current
shareholders.
2. Customer assurance program.
3. Staggered board.
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 Leveraged Buyouts
Leveraged buyout, or LBOs: Acquisition of the firm by a private group
using substantial borrowed funds.
◦ Large portion of buy-out financed by debt.
◦ Shares of the LBO no longer trade on the open market.
Management buyout, or MBOs: Acquisition of the firm by its own
management in a leveraged buyout.
Motivations
◦ Cheap money: junk bond market.
◦ Leverage and incentives: Improving operating efficiency.
◦ Free cash flow: mature “cash cow” companies are often the targets
in LBOs.

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 Divestures, Spin-Offs or Carve-Outs
Divestiture
◦ When a firm sells some of the assets to another entity as a going
concern.
Spin-Off
◦ The process of a business separating the ongoing operations of a
unit of that business and giving the shareholders of the parent
firm shares of the unit.
Carve-Outs
◦ Similar to a spin-off, but issues shares of the new firm to the
public.

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 • Chapter 29 of Corporate Finance, 11th, by Ross,
Supplementary Westerfield, Jaffe and Jordan
Reading • Chapter 22 of Fundamentals of Corporate
Finance, 3rd, by Berk, DeMarzo and Harford