AFU 07303: Corporate Finance

Mergers and Acquisitions

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On completion of this session, you should
be able to:
 understand why firms engage in mergers
and acquisitions
 calculate the value of a merger to the
acquiring company
 understand the financing issues associated
with mergers and other forms of corporate
restructuring,
 understand the possible agency problems
between managers and shareholders
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 Types of merger
 Horizontal mergers combine firms in the
same business (most mergers like this)
 Vertical mergers combine firms at
different stages of production in the
same “industry”.
 Conglomerate mergers combine firms in
different industries
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Production reasons for acquisition
 Expanding capacity.
 Economies of scale.
 Combining complementary resources
 Acquiring technology.
 Vertical integration, for quality control
or supply reasons.
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Marketing reasons for acquisition
 Expanding market share.
 Extending product range.
 Gaining entry to new markets.
 Eliminating competition.

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Miscellaneous reasons for acquisition
 Target company’s shares or assets
‘under-priced’.
 Acquirer’s shares ‘overvalued’.
 Applying superior management skills to
the acquiree’s business.
 Preventing a competitor from acquiring
the target company.
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Miscellaneous reasons for acquisition
 Making the acquiring company itself
less attractive to a predator.
 Tax benefits (such as the ability to
utilise tax losses).
 Diversifying business risk.
 Empire building.

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 Ownership reasons for selling
 The owner wants to diversify risk.

 The owner wants to reduce inheritance

tax on death.

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Management reasons for selling
 Manager(s) about to retire, with no
obvious successor.

 Poor business prospects under the

control of the present management,
possibly following an expansion or a
change of direction.

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Reasons for selling part of a group
 Vendor company needs extra source of
finance.
 No longer fits with core business or
strategy of vendor group.
 Makes vendor less attractive to a
predator.

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Agency problem: managers versus shareholders
 Managers will be anxious to diversify away
most of their company’s ‘unique risk’.
 Hence, managers may undertake acquisitions
to reduce their company’s total risk
 But shareholders are able to diversify away
firm specific risk more cheaply simply by
holding a portfolio of shares

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 Valuation of Companies
 Various ways
 Unlevered/Ungeared firm (All equity firms)
 Levered/Geared firm

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 Bargaining
 Both buyer and seller may have in mind
a range of suitable prices.

 If they overlap, a deal should be

possible, although the range may alter
during the bargaining process

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 Payment by cash or share issue?
 The shareholders of the target company
and the bidding company are likely to
have different views about the
advantages of an offer of cash or
shares,

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 Viewpoint of the target firm’s
shareholders
Value of Liquidity Capital Interest in
offer Gains target firm
Tax

Cash Certain Improved Payable Lost

Shares Uncertain Unchanged Delayed Diluted

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 Viewpoint of the bidding firm’s
shareholders
Likely Firm Firm Transaction Interest in
success liquidity gearing costs to bidding
firm firm

Cash Known if Squeezed May Negligible Unchanged

reasonably may need increase
priced to borrow

Shares Depends Slightly Depends Share issue Diluted

on size of reduced on costs
bidding target's
firm. debt level

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Example
 Consider the following information for two all-equity
firms, A and B;
Firm A Firm B

Shares Outstanding 2000 6000

Prize per share (TZS) 40 30

 Firm A estimates that the value of the synergistic

benefit from acquiring Firm B is TZS 6000. Firm B
indicated that it would accept a cash purchase offer
of TZS 35 per share. Should Firm A proceed?

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Suggested Solution
 The total value of Firm B to Firm A is the premerger value of B
plus the TZS 6000 gain from the merger.
 The premerger value of B is TZS 30 X 6000= TZS 180,000
 So the total value is TZS 180,000+ TZS 6000=TZS 186,000
 At TZS 35 per share, Firm A is paying TZS 35 X 6000= TZS
210,000
 The merger therefore has a negative NPV OF TZS 186,000- TZS
210,000= - TZS 24,000
 Thus at TZS 35 per share, Firm B is not attractive merger
partner.

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 Human consequences
 Making a merger work takes a great
deal of management time and effort.
 Employees may lose their jobs
 Employees could be demoted
 Employees may have to relocate

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 Restructuring via demerging
 There are three main ways of
restructuring a company via a
demerger:
 sell offs,
 spin-offs,
 management buy-outs.

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 Sell-offs
 Assets usually sold for cash to an existing
business.
 Sell-off is the rapid selling of securities such
as stocks, bonds and commodities.
 A sell-off may occur for many reasons, such
as the sell-off of a company's stock after a
disappointing earnings report.

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 Spin-offs
 Effectively, part of a business is
floated off as a separate business
(normally quoted).
 The shareholders are given shares in
the new entity pro rata to their
shareholding in the original parent

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 Spin-offs
 A company will spin off a unit to rid itself of
an underperforming part of its business.
 If the core part of the business is
underperforming, the company may spin off a
new, up-and-coming area of its business to
give the new subsidiary a better chance to
flourish and reach its full value. In addition,
the parent company now can focus on its
core competencies.

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Management buy-outs (MBO’s)
 The management team arranges to buy an
equity stake in the business.
 Venture capitalists back them by putting up
the rest of the purchase price.
 The normal ‘plan’ is to float the firm on the
Stock Exchange at some future point,
repaying most of the initial finance

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 Leveraged buy-out
(US term for MBO)
 In order for the buy-out team to
maintain a reasonable degree of equity
control and because its resources are
likely to be limited, large amounts of
debt are often used in the financing
package

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 The End

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