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Mergers and Acquisitions

Mergers and Acquisitions
Mergers and Acquisitions

CHAPTER 29

Mergers and Acquisitions

Concept Questions (Ross Westerfield Jaffe)

  1. Merger Rationale Explain why diversification per se is not probably a good reason for merger.

Answer:

Diversification doesn’t create value in and of itself because diversification reduces unsystematic,  not  systematic,  risk.  There  is  a  more  subtle issue as  well.  Reducing unsystematic risk benefits bondholders by making default less likely. [blur]However, if a merger is done purely to diversify (i.e., no operating synergy), then the NPV of the merger  is  zero.  If  the  NPV  is  zero,  and  the  bondholders  are  better  off,  then stockholders must be worse off.[/blur]

Merger and Taxes

[blur]Describe the advantages and disadvantages of a taxable merger as opposed to tax-free exchange. What is the basic determinant of tax status in a merger? Would an LBO be taxable or non-taxable? Explain.[/blur]

Answers:

[blur]One of the primary advantages of a taxable merger is the write-up in the basis of the target firm’s assets, while one of the primary disadvantages is the capital gains tax that is payable. The situation is the reverse for a tax-free merger.[/blur]

[blur]The  basic  determinant  of  tax  status  is  whether  or  not  the  old  stockholders  will continue to participate in the new company, which is usually determined by whether they  get  any  shares in  the  bidding  firm.  An  LBO is  usually  taxable  because  the acquiring group pays off the current stockholders in full, usually in cash.[/blur]

Economies of scale

[blur]What does it mean to say that a proposed merger will take advantage of available economies of scale? Suppose Eastern Power Co. and Western Power Co. is located at different time zones.  Both operate at 60% capacity except for peak periods when they operate at 100% of capacity.  The peak periods begin at 9 a.m. and 5 p.m. local time and last about 45 minutes.  Explain why a merger between Eastern and Western might make sense. Discuss.[/blur]

Answers:

[blur]Economies of scale occur when average cost declines as output levels increase. A merger in this particular case might make sense because Eastern and Western may need  less  total  capital  investment  to  handle  the  peak  power  needs,  thereby reducing average generation costs.[/blur]

Hostile Takeovers

[blur]What types of actions might the management of a firm take to fight hostile acquisition bid from an unwanted investor? How do the  target  firm shareholders benefit from the defensive tactics of their management team? How are target firm shareholders harm by such actions? Explain.[/blur]

Answers:

[blur]Among the defensive tactics often employed by management are seeking white knights, threatening to sell the crown jewels, appealing to regulatory agencies and the courts (if possible), and targeted share repurchases.[/blur]

[blur]Frequently, anti-takeover charter amendments are available as well, such as poison pills, poison puts, golden parachutes, lockup agreements, and supermajority amendments, but these require shareholder approval, so they can’t be immediately used if time is short.[/blur]

[blur]While target firm shareholders may benefit from management actively fighting acquisition bids, in that it encourages higher bidding and may solicit bids from other parties as well, there is also the danger that such defensive tactics will discourage potential  bidders  from  seeking  the  firm  in  the  first  place,  which  harms  the shareholders.[/blur]

Merger Profits

[blur]Acquiring firm stockholders seem to benefit little from takeovers. Why is this finding a puzzle? What are some of the the reasons offered for it?[/blur]

Answers:

Various reasons include:

(1) [blur]Anticipated gains may be smaller than thought; (2) Bidding firms are typically much larger, so any gains are spread thinly across shares; (3) Management may not be acting in the shareholders best interest with many acquisitions;(4) Competition in the market for takeovers may force prices for target firms up to the zero NPV level; and (5) Market  participants  may  have  already  discounted  the  gains  from  the  merger before it is announced.[/blur]

Questions and Problems

Calculating Synergy

[blur]Evan Inc. has offered $340 million cash for all the common stock in Tanner Corporation.   Based on recent  market information, Tanner is worth $317 million as an independent operation.  If the merger makes economic sense for Evan, what is the minimum estimated value of the synergies benefits from the merger?[/blur]

Answers:

[blur]For the merger to make economic sense, the acquirer must feel the acquisition will increase value by at least the amount of the premium over the market value:[/blur]

[blur]Minimum economic value = $340,000,000 – 317,000,000 = $23,000,000[/blur]

Balance Sheets for Mergers

[blur]Consider the following premerger information about firm X and Y[/blur]

  Firm X Firm Y
Total Earnings($) [blur]90,000[/blur] [blur]52,200[/blur]
Shares outstanding(units) [blur]46,800[/blur] [blur]36,000[/blur]
Pre-share values($): Market

 

Book

53

21

19

9

[blur]Assume that Firm X acquires Firm Y by paying cash for all the shares outstanding at a merger of $5 per share.  Assuming that neither firm has any debt before or after the merger, construct the postmerger balance sheet for Firm X assuming the use of the purchase accounting method.

Solutions:

[blur]With the purchase method, the assets of the combined firm will be the book value of Firm X, the acquiring company, plus the market value of Firm Y, the target company, so:[/blur]

[blur]Assets from X = 46,800($21) = $982,800 (book value) Assets from Y = 36,000($19) = $684,000 (market value)

[blur]The purchase price of Firm Y is the number of shares outstanding times the sum of the current stock price per share plus the premium per shares,so:[/blur]

[blur]Purchase price of Y = 36,000($19 + 5) = $864,000[/blur]

[blur]The goodwill created will be:[/blur]

[blur]Goodwill = $864,000 – 684,000 = $180,000[/blur]

[blur]And the total assets of the combined company will be:[/blur]

[blur]Total assets XY = Total equity XY = $982,800 + 684,000 + 180,000 = $1,846,800 [/blur]

[blur]Assume that the following balance sheets are stated of book value.  The fair market value of James’ fixed assets is equal to the book value.   Jurion pays $15,000 for James and raises the needed funds through an issue of long term debt. Construct  the  postmerger  balance  sheet  now,  assuming  that  the purchase method of accounting is used.[/blur]

 

Jurion Co. ($)
Current Assets 18,000 Current Liabilities 5,100
Net Fixed Assets [blur]33,000[/blur] Long-term debt 9,300
    Equity [blur]36,600[/blur]
Total [blur]51,000[/blur]   [blur]51,000[/blur]
James. Inc. ($)
Current Assets 3,500 Current Liabilities 2,100
Net Fixed Assets [blur]8,900[/blur] Long-term debt 1,400
    Equity 8,900
Total [blur]12,400[/blur]   12,400

Solutions:

[blur]Since the acquisition is funded by long-term debt, the post-merger balance sheet will have long-term debt equal to the original long-term debt of Jurion’s balance sheet plus the new long-term debt issue, so:[/blur]

[blur]Post-merger long-term debt = $9,300 + 15,000 = $24,300[/blur]

[blur]Goodwill will be created since the acquisition price is greater than the market value. The goodwill amount is equal to the purchase price minus the market value of assets. Generally, the market value of current assets is equal to the book value, so:[/blur]

[blur]Goodwill created = $15,000 –$8,900 (market value FA) – $3,500 (market value CA) = $2,600[/blur]

[blur]Current liabilities and equity will remain the same as the pre-merger balance sheet of the acquiring firm. Current assets will be the sum of the two firm’s pre- merger balance sheet accounts, and the fixed assets will be the sum of the pre- merger fixed assets of the acquirer and the market value of fixed assets of the target firm. The post-merger balance sheet will be:[/blur]

Jurion Co., post-merger

Current assets [blur]$21,500[/blur] Current liabilities $ 5,100
Fixed assets [blur]41,900[/blur] Long-term debt 24,300
Goodwill     2,600 Equity   36,600
Total [blur] $66,000 Total [blur]$66,000[/blur]

Mergers and Acquisitions

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