Chapter Six (6)

Merger and Acquisitions

Advanced Financial Management

24/01/2024

By Section One students

Objectives
 What are mergers and acquisitions?
 The reasons for merger and acquisitions?
 Types of merger and acquisitions.
 Forms of merger and acquisitions.
 The concept of synergy in merger and acquisition
 Types of synergy
 Basic source and reasons for synergy
 The financial side effects of merger and acquisition
What are mergers and acquisitions?
 The term mergers and acquisitions (M&A) refers to the
consolidation of companies or their major business assets
through financial transactions between companies.

Merger
• A merger is referred to as a financial transaction in which two
companies join each other and continue operations as one legal
entity.

Acquisition
• An acquisition is defined as a corporate transaction where one
company purchases a portion or all of another
company’s shares or assets.
Why we need merger and acquisition?

Mergers and acquisitions (M&A) can take place for various reasons, such as:

 Value creation

 Acquisition asset

 Higher growth

 Stronger market power

 Diversification

 Tax benefits

 Incentives for manager

Advantages/disadvantages of organic growth and acquisition

Advantages of organic growth (disadvantages of Advantages of growth by acquisition (disadvantages of

growth by acquisition) organic growth)

 Reduced entry barriers  Culture clashes

 Market power  Duplication
 New competencies and resources  Conflicting objectives
 Access to experts  Poorly matched businesses
 Access to capital  Pressure on suppliers
 Fresh ideas and perspective  Brand damage
 Types of merger and acquisitions

1. Horizontal

A horizontal merger happens between two companies

that operate in similar industries that may or may not
be direct competitors.

2. Vertical

A vertical merger takes place between a company

and its supplier or a customer along its supply chain.
The company aims to move up or down along its
supply chain, thus consolidating its position in the
industry.
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3. Conglomerate

 This type of transaction is usually done for diversification reasons and is

between companies in unrelated industries.

4. Congeneric merger (also ‘Concentric merger’)

In a congeneric merger, the acquirer and target company have different products or
services, but operate within the same market and sell to the same customers. They
could be indirect competitors, although their products often complement each
other.
 Issues raised under merger and acquisitions

Competitive issues
Corporate issues

• Impact on board
• When considering acquisitions and mergers the
• Board hostility. competitive aspects need to be considered.
• Impact on corporate governance. • One of the motives for acquiring a company is
to remove competitive rivalry from the market.
• Culture differences
• Loss of key personnel from target company.
• Integration difficulties
• Adverse PR
Mergers and Acquisitions (M&A) – Forms(ways) of Integration

1. Statutory

 Statutory mergers usually occur when the acquirer is much larger than the target
and acquires the target’s assets and liabilities. After the deal, the target company
ceases to exist as a separate entity.

2. Subsidiary

 In a subsidiary merger, the target becomes a subsidiary of the acquirer but

continues to maintain its business.

3. Consolidation

 In a consolidation, both companies in the transaction cease to exist after the deal,
and a completely new entity is formed.
 Basic forms of mergers and acquisitions (M&A)
1. Stock purchase

In a stock purchase, the acquirer pays the target firm’s

shareholders cash and/or shares in exchange for shares of the
target company.

There are certain aspects to be considered in a stock purchase:

•The acquirer absorbs all the assets and liabilities of the target –
even those that are not on the balance sheet.

•To receive the compensation from the acquirer, the target’s

shareholders must approve the transaction through a majority
vote, which can be a long process.

•Shareholders bear the tax liability as they receive the

compensation directly.
Practical example:
Let's say Company A wants to purchase certain assets from Company B. Company B agrees to sell the
following assets to Company A:
Equipment: Company B owns manufacturing equipment worth $500,000.
Licenses: Company B holds exclusive licenses for a patented technology, valued at $200,000.
Goodwill: Company B has established a strong brand reputation, which is estimated to have a goodwill value
of $300,000.
Customer Lists: Company B has a database of loyal customers, valued at $100,000.
Inventory: Company B's current inventory consisting of raw materials and finished goods is valued at
$400,000.
In this scenario, Company A will acquire these specific assets from Company B while Company B will retain
legal ownership of the entity.
The total consideration for the asset purchase would be the sum of the individual asset values:
Total Consideration = Equipment + Licenses + Goodwill + Customer Lists + Inventory Total Consideration =
500,000+200,000 +300,000+100,000 + 400,000=
Total Consideration=1,500,000
Therefore, Company A will purchase these assets from Company B for a total consideration of $1,500,000.
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2. Asset purchase

In an asset purchase, the acquirer purchases the target’s assets and

pays the target directly.

There are certain aspects to be considered in an asset purchase,

such as:

•Since the acquirer purchases only the assets, it will avoid assuming
any of the target’s liabilities.

•As the payment is made directly to the target, generally, no

shareholder approval is required unless the assets are significant
(e.g., greater than 50% of the company).

•The compensation received is taxed at the corporate level as capital

gains by the target.
Example,
Let's say Company A wants to acquire Company B. Company A offers to purchase all
outstanding shares of Company B from its shareholders. The agreed-upon deal is that for
each share of Company B, the shareholders will receive $50 in cash and 0.5 shares of
Company A's stock. - Company B has 1,000,000 shares outstanding. - Company A's stock is
currently trading at $100 per share.
In this scenario, Company A will pay cash and issue shares to the shareholders of Company
B. therefore, Company A agrees to acquire Company B.
Shareholders of Company B will receive $50 in cash and 0.5 shares of Company A's stock
for each share of Company B.
Company B has 1,000,000 shares outstanding.
Company A's stock is currently trading at $100 per share.
As a result of the acquisition, Company B shareholders will receive $50,000,000 in cash
(50,000,000 in cash (50 * 1,000,000 shares) and 500,000 shares of Company A's stock (0.5
shares * 1,000,000 shares) as per the agreed terms.
 Advantage & disadvantage of asset purchase transaction
Advantages
"Step up" in basis of assets allows for tax
deductions on depreciation and/or amortization.
Amortization of goodwill over 15 years is possible
for tax purposes.
The buyer can choose which liabilities to assume,
limiting exposure to unknown or significant
liabilities.
The buyer can select which assets to purchase and
exclude specific ones, such as uncollectable accounts
receivable.
Due diligence process is generally less time-
consuming and resource-intensive due to limited
exposure to unknown liabilities.
Minority shareholders can be compelled to accept
the terms of an asset sale, unlike in a stock purchase.
The buyer has flexibility in selecting which
employees to retain without affecting unemployment
Disadvantages
Contracts with customers and suppliers may require
renegotiation or renewal by the new owner.
The tax cost for the seller is typically higher, leading to
a potential demand for a higher purchase price.
There may be limitations on assignable contract rights.
Assets may need to be retitled in the name of the new
owner.
Employment agreements with key employees may need
to be renegotiated.
The seller is responsible for liquidating any remaining
assets, paying outstanding liabilities, and terminating
leases.
Additional legal and administrative tasks may be
required to transfer ownership of the assets.
Advantage & disadvantage of a stock purchase
Advantages
The
acquirer avoids costly re-valuations and
retitles of individual assets.
Buyers
can generally assume non-assignable
licenses and permits without needing specific
consent.
Buyers
may be able to avoid paying transfer
taxes.
Stock
purchases are simpler and more commonly
used compared to asset acquisitions.
Hedge
funds often conduct M&A transactions
using the straightforward stock purchase method.
Disadvantages
The acquirer does not receive the tax benefit of a
"step-up" in the asset's value or the ability to
handpick assets and liabilities.
All assets and liabilities transfer at their carrying
value, limiting the ability to adjust their values.
Unwanted liabilities can only be addressed through
separate agreements with the target company.
Compliance with securities laws can complicate the
process, especially if the target has many
shareholders. Some shareholders may not wish to
sell, prolonging the acquisition process and
increasing costs.
Goodwill, when in the form of a share price
premium, is not tax-deductible.
Method of payment
There are two methods of payment – stock and cash.

A. Stock B. Cash

In a stock offering, the acquirer issues new shares that In a cash offer, the acquirer simply pays cash in return
are paid to the target’s shareholders. The number of for the target’s shares.
shares received is based on an exchange ratio, which is
finalized in advance due to stock price fluctuations.
Steps in identifying merger and acquisition targets

• Strategic steps:
Step 1: Appraise possible acquisitions.

Step 2: Select the best acquisition target.

Step 3: Decide on the financial strategy, i.e. the amount and the
structure of the consideration.

• Tactical steps:
Step 1: Launch a dawn raid subject to relevant regulation.

Step 2: Make a public offer for the shares not held.

Step 3: Success will be achieved if more than 50% of the target

company’s shares are acquired.
Information required for the appraisal of merger and acquisitions

The following needs to be considered when appraising a target for

merger and acquisition:

• Organization

• Sales and marketing

• Production, supply and distribution

• Technology

• Accounting information

• Treasury information

• Tax information.
Mergers and Acquisitions (M&A) – Valuation

 In an M&A transaction, the valuation process is conducted by the acquirer, as well as the
target. The acquirer will want to purchase the target at the lowest price, while the target
will want the highest price.

 Thus, valuation is an important part of mergers and acquisitions (M&A), as it guides the
buyer and seller to reach the final transaction price.

Below are three major valuation methods that are used to value the target:

• Market based method: Under this the investing community often uses market
capitalization value to rank companies and compare their relative sizes in a particular
industry or sector.
Book value model: Book value is primarily important for investors using a value investing
strategy because it can enable them to find bargain deals on stocks, especially if they suspect
that a company is undervalued and/or is poised to grow, and the stock is going to rise in price.

• Free cash flow model: it views the intrinsic value of a company as the present value of
its expected future cash flow.
What is Synergy?

Synergy is the concept that the whole of an entity is worth

more than the sum of the parts. This logic is typically a
driving force behind mergers and acquisitions (M&A),
where investment bankers and corporate executives often use
synergy as a rationale for the deal.

In other words, by combining two companies in a merger, the

new company’s value will be greater than the sum of the
values of each of the two companies being merged.
 Importance of synergy in mergers and acquisitions

 Synergy is the basis of mergers, acquisitions, or

strategic alliances. Such strategic actions create
economies of scope by exploiting each party’s
resources and capabilities.
 Types of synergy that can be achieved in an M&A process
A. Cost savings
 Cost saving synergy – usually referred to as
operational synergy – can be achieved by
eliminating redundant costs, gaining better
bargaining power with suppliers and vendors,
and improving operational efficiencies.
Types of cost synergies
.
 Supply Chain Efficiencies
 Improved Sales and Marketing
 Research and Development
 Lower Salaries and Wages
 Redundant Facilities
 Patents and Intellectual Property (IP)
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B. Revenue enhancements

Revenue enhancements are derived from the financial

synergy that can be achieved by such things as cross-
selling complementary products to customers, having more
pricing power with consumers, and expanding or being
able to enter into new markets and new geographical
locations.

Types of Revenue Synergies

 Patents

 Complementary products

 Complementary geographies and customers

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C. Financial synergies
 Financial synergies occur when the merged firm is able to better
improve its capital structure compared to when the companies
were separate. Capital structure changes potentially result in
increased benefits in terms of tax savings and debt capacity.

 If successful, the merged firm can theoretically reduce its cost of

capital, thereby resulting in a higher valuation versus the
standalone companies.

Types of financial synergies.

 Diversification and Cost of Equity

 Increased Debt Capacity

 Tax Benefits
The impacts of merger and acquisitions on stake holders

 Impact on acquiring company's shareholders

 Impact on the target company's shareholders

 Impact on lenders/debt holders

 Impact on managers and staff

 Impact on society as a whole