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Lecture 11: Mergers, Acquisitions and Corporate Control

The Number of Mergers in the United States(1962-2009)

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Types of Mergers

Horizontal MergerA merger between two firms in the same line of business (former competitors)

Vertical MergerA merger between companies at different stages of production

Conglomerate Merger

A merger between companies in unrelated lines of business

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Sensible Reasons for Mergers

Economies of Scale

Economies of Vertical Integration

Combining Complementary Resources

Mergers as a Use for Surplus Funds

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Economies of Scale

With economies of scale, a larger firm may be able to reduce its per unit cost.

How?

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Economies of Vertical Integration

Control over suppliers “may” reduce costs. Over-integration can cause the opposite effect.

Pre-integration (less efficient)

Company

S

S

S

S

S

S

S

Post-integration (more efficient)

Company

S

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Combining Complementary Resources

Merging may result in each firm filling in the “missing pieces” of their firm with pieces from the other firm.

Firm A

Firm B

Example: 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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Use for Surplus Funds

If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.

What might this imply about the pre- and post-acquisition PVGO?

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Dubious Reasons for Mergers

Diversification

The Bootstrap Game

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Diversification

Diversification Investors should not pay a premium for

diversification since they can do it themselves.

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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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The Bootstrap Game: Example

World Enterprises (before merger) Muck and Slurry

World Enterprises (after buying Muck

and Slurry)

EPS $2.00 $2.00 $2.67Price per share $40.00 $20.00 $40.00P/E Ratio 20 10 15Number of shares 100,000 100,000 150,000 Total earnings $200,000 $200,000 $400,000Total market value $4,000,000 $2,000,000 $6,000,000

Current earnings per dollar invested in stock $0.05 $0.10 $0.067

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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

Tender Offer – The acquiring firm buys all the stock of the target firm

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 Mergers Ask:

Is there an overall economic gain to the merger? Do the terms of the merger make the company

and its shareholders better off?

( ) ( ) ( )PV A B PV A PV B

Synergy

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Financing Mergers

Mergers Financed by Cash

Mergers Financed by Stock

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Evaluating Mergers

Economic Gain = PV(increased earnings)

= New cash flows from synergies

discount rate

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Evaluating Mergers: ExampleGiven a 20% cost of funds, what is the economic gain, if any, of

the merger listed below? (GenPharm acquires Biotex)

GenPharm Biotex Combined Company

Revenues 200 25 225 (+0)

Operating Costs 110 17 120 (- 7)

Earnings 90 8 105 (+7)

7Economic Gain= $35

.20

Which of the “sensible reasons” for a merger is this merger most likely based on?

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The Market for Corporate Control

1. Proxy Contests

2. Takeovers

3. Leveraged Buyouts

4. Divestures, Spin-Offs or Carve-Outs

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Proxy ContestsProxy

The right to vote another shareholder’s shares

Proxy Contests

Takeover attempt in which outsiders compete with management for shareholders’ votes

Proxy Access (2010)

Problem with Proxy Contests?

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Takeovers

Tender Offer: a direct offer of purchase to current shareholders, without consulting with management

How can management react to a tender offer?

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Takeover Defensive Tactics

White Knight

Shark Repellent

Poison Pill

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Leveraged Buy-Outs (LBO)

Large portion of buy-out financed by debt

Shares of the LBO no longer trade on the open market

Leveraged Buyout vs. Management Buyout

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Potential Gains from an LBO

Junk bond marketLeverage and taxesOther stakeholdersLeverage and incentivesFree cash flow

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Divestitures, Spin-Offs, and 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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Benefits and Cost of Mergers

Who usually benefits from a merger?

Who usually loses in a merger?