Lecture 1:

1. Managerial Motives to Merge:

Studies have consistently found that the stock price of large bidders drops on
average when a bid is announced, especially when the target is publicly traded.
Two possible explanations might be conflicts of interest with their
shareholders and overconfidence.

Conflicts of Interest: Managers may prefer to run a larger company due to the
additional pay and prestige it brings. Because most CEOs hold only a small
fraction of their firm’s stock, they may not bear enough of the cost of an
otherwise bad merger that increases their personal benefits.

Eg: a CEO who owns 1% of her firm’s stock bears 1% of every dollar lost on a
bad acquisition, but enjoys 100% of the gains in compensation and prestige that
come with being the CEO of a larger company. If the acquisition destroys $100
million in shareholder value, but increases the present value of her
compensation by more than $1 million, she will prefer to execute the merger
anyway.

 • Why would the board of directors create these incentives?: This means that the
board of directors may pay the manager more money or give him more power if
he makes the firm bigger by buying other firms, even if those acquisitions are not
profitable or beneficial for the shareholders.
Either due to poor monitoring of the manager, or belief that the strategy is
correct even if the stock market disagrees: This means that there are two
possible reasons why the board of directors may create these incentives. One
reason is that the board of directors does not supervise or control the manager
well enough, and lets him use the free cash flow (the excess money that the firm
generates after investing in all positive net present value projects) to make
acquisitions that serve his own interests rather than the shareholders'. Another
reason is that the board of directors believes that the manager's strategy of
making acquisitions is correct, even if the stock market does not agree and
lowers the value of the firm's shares.
Boards typically increase the pay of CEOs along with the size of the firm, even if
the size comes at the expense of poorly performing acquisitions: This means that
it is a common practice for boards of directors to reward CEOs with higher
salaries or bonuses as the firm grows larger, regardless of whether the growth is
due to good or bad acquisitions. This creates a problem because it encourages
CEOs to make acquisitions that increase their own pay but decrease shareholder
value.
 • Managers or controlling shareholders may also exploit their informational
advantage: This means that managers or controlling shareholders may use their
knowledge or information about the firm that is not available to the public or the
market. They may have access to private or confidential data, such as future
earnings, projects, or strategies, that affect the value of the firm.

• by choosing to acquire their own firm when it is undervalued by the market:

This means that managers or controlling shareholders may decide to buy more
shares of their own firm when the market price of the firm is lower than its true
value. They may do this by making a tender offer (a public offer to buy a large
number of shares at a specified price) or by buying shares in the open market.
By doing this, they can increase their ownership and control of the firm, and
benefit from the increase in the value of the firm when the market realizes its true
value.

Overconfidence: overconfident CEOs pursue mergers that have low chance of

creating value because they truly believe that their ability to manage is great
enough to succeed. The critical distinction between this hypothesis and the
incentive conflict discussed above is that overconfident managers believe they
are doing the right thing for their shareholders, but irrationally overestimate their
own abilities. Under the incentive conflict explanation, managers know they are
destroying shareholder value, but personally gain from doing so.

VALUATION AND THE TAKEOVER PROCESS:

- Valuation: Using 2 different approaches:

+ Compare the target to other comparable companies: But this not directly
incorporate the operational improvements and other synergistic efficiencies
that the acquirer intends to implement. -> need a more accurate estimate of
value including careful analysis of both operational aspects of the firm
and the ultimate cash flows the deal will generate.
+ Make a projection of the expected cash flows that will result from the deal

Amount paid = Target’s Pre-bid market capitalization + Acquisition Premium

Bidders’ standpoint:
Value acquired = Target stand-alone value + PV (Synergies)

 Takeover is a positive-NPV project only if the premium paid not exceed the
Synergies created.
THE OFFER
- Tender offer: a public announcement of its intention to purchase a large block
of shares for a specified price.
+ use either of two methods to pay for a target: cash or stock