CorporatefinanceEighthEditionChapter11MergersandtakeoversTerminologyAmergerisareorganisationofassetsbetweentwoequal-sizedcompanieswhoagreetojointogether.Truemergersarecomparativelyrare.Atakeover(acquisition)isthebuyingofthesharecapitalofonecompanybyanother.Acquisitionsarequitecommonandmaybefriendlyorunfriendlyinnature.Terminology(continued)HorizontalAcquisition:Companiesinthesameindustryandstage

ofproductioncombineintoasingleentity.Mostcommonacquisition,mostlikelytosucceed,mostlikelytobereferredtotheCompetitionandMarketsAuthority(CMA).Example:CMAinvestigationofproposedmergerbetweenSSEandNpower(seeVignette11.3).Terminology(continued)VerticalAcquisition:Companiesinthesameindustryatdifferentstagesofproductioncombine,eitherbackwardstowardssuppliersorforwardstowardsdistribution.Securesvitaloutletsforfinishedproductsornecessarysourcesofrawmaterials.Terminology(continued)ConglomerateAcquisition:CompaniesindifferentindustriesmergeLeastlikelytobereferredtoCMALeastlikelytobesuccessfulJustificationsforacquisitionIfmarketvalueofnewfirmexceedsseparatemarketvalues,shareholderwealthincreasesPVX+Y>(PVX+PVY)Economicmotivesseektoraisecashflowsbyincreasingrevenueordecreasingcosts.Synergyarisewhencomplementaryactivitiesleadtoincreasingprofitoroutput.Operating,financialandmanagerialsynergyhavebeenidentified.Justificationsforacquisition(continued)Economiesofscale:Largerscaleofoperationsormoreefficientuseofassetsfollowinganacquisitionleadstoadecreaseinaverageunitcost.Economiesofscalecanoccurinproduction,distribution,marketingandsoon.Economiesofscalemaybeseenasan

operatingsynergy.Justificationsforacquisition(continued)Eliminationofinefficientmanagement:Ifcompanyispoorlyrun,itssharepricewillfallanditbecomesatargetforacquisition.Increasedoutputorrevenueandlowercostscanarisefromtransferofmanagerialskillsoreliminationofinefficientmanagers.Managerialskillsofacquirercomplementassetsoftargetfirm,hencehigherprofits.Justificationsforacquisition(continued)Increasedcashflowscanalsoarisefromarangeofmarket-relatedfactors: Newmarketentryforexistingproducts, e.g.acquisitionfasterthanorganicgrowth Criticalmassachieved,e.g.minimumsizetoeffectivelycarrycostssuchasR&D Growthofmarketshare IncreasedmarketpowerormarketshareJustificationsforacquisition(continued)Financialsynergy:Thisreferstodecreaseincostofcapitalthroughacquisition.Increasedsizecanleadtofinancingscaleeconomies,e.g.lowerissuecosts.Increasedsizecanyieldlowerinterestratesandlowercostofdebtduetolowerrisk.Decreasedcashflowvolatilitycanalsodecreaseriskandlowercostofcapital.Justificationsforacquisition(continued)Targetundervaluation:Iftargetcompanysharesareundervalued,capitalmarketscannotbeefficient.Whetheravalidreasonforacquisitionwilldependontheviewofcapitalmarketefficiency.Evidencesuggestsmarketsareefficient.Valuationuncertaintydoesleavesscopeforundervaluation.Justificationsforacquisition(continued)Earningspershare:IfacquirerhashigherPERthantarget,itcanincreaseitsEPSbyusingshare-for-shareoffer.IfPERstaysthesame,themarketvalue

willrise.IncreasingEPSthiswayis‘bootstrapping’.Bootstrappingdoesnotincreasethewealthofshareholdersasitdoesnotgeneratecash.Marketmaygiveadifferentvaluetonewfirm.Managerialmotives:Agencyproblemcanmanifestthroughacquisitions.Motiveforacquisitionsmaybepower,remuneration,perks,jobsecurity.Managerialmotivescanleadtodecreaseinshareholderwealth.Acquiringshareholdersrarelybenefit.Justificationsforacquisition(continued)AgainstacquisitionReferraltoCMA:DamagesimageandwealthofacquirerFormalinvestigationmeanslongcostlydelayAcquisitionmaybeblockedoramendedBidiscontested:LargeacquisitionpremiumifbidcontestedPremiumupto50%notuncommonAreacquisitionsbeneficialanyway?Costoffinancingacquisition:Share-for-shareoffer:AcquirermustpaydividendsonnewsharesOwnershipandcontrolchangesCashoffer(financedbydebt):GearinglevelsmayincreasesharplyInterestpaymentsmaybehardtomeetAcquisitiontransactioncosttobemetAgainstacquisition(continued)Againstacquisition(continued)Otherdifficulties:CulturalproblemsExchangeraterisk(cross-bordermergers)ComplextaxationandlegalissuesQualityofassetspurchasedmaybeuncertainMergerwavesMergersandacquisitionsoccurinwaves:UK1972–73,UKlate70sUKlate1980s(conglomerate)UKmid1990s(horizontal)WavestendtobecharacterisedbydifferenttypesofmergerandacquisitionactivitiesanddifferentmotivesMergerwaves(continued)Mergerwaveshavebeenlinkedto:businesscycles;deregulationoffinancialsystemandmarkets;companyprofitabilityandliquidity;corporatefads,suchasacorebusinessfocusorcorporatediversification;globalisationofmarkets;changingmarketconditions;changesinantitrustlegislation.StockmarketvaluationNumberofsharestimesmarketpricepershareFairpriceifmarketisefficient,butnotfixedQuotedpricereflectsmarginaltradingCannotbeusedforunquotedsharesUsefulstartingpointinnegotiationsMVdoesnotreflectacquirerintentions Hulseplchas123m/0.5=246msharesMarketvalue=246m×￡2.50=￡615mAsset-basedvaluationsNAV(bookvalue)Non-currentassets+netcurrentassets

long-termdebtUseshistoriccosts,whichthoughfactualandavailable,donotreflectcurrentvaluationsUsuallylowerlimitofacompany'svalue HulseNAV=290m+27m

175m=￡142mAsset-basedvaluations(continued)NAV(netrealisablevalue)Residualvalueaftersellingassets,lessliquidationcostsandotherliabilitiesMarketvalueshouldbehigherCalculationhamperedbylackofinformationInventorymaybeworthlessinquicksaleAssetsofsomecompaniesareuniqueProvisionsforunforeseenliabilitiesneeded HulseNAV=270m+27m–175m=￡122mAsset-basedvaluations(continued)NAV(replacementvalue)CostofbuyingassetsonopenmarketbasisReplacementcostvaluestheoreticallymorerelevantthanhistoriconesDoesnottakeaccountofgoodwillHardtogetdataforthisvaluationmethod HulseNAV=305m+27m

175m=￡157mEarningsyieldvalueValueoffirm=annualmaintainableearnings

earningsyieldEarningsyield(capitalisationrate)shouldreflectsizeoffirmandnatureofitsbusiness Hulseplcearningsyield=EPS/shareprice =(18.4/250)×100=7.36%Hulseearningsyieldvalue(ignoringgrowth) =45.29m/0.0736=￡615mEarningsyieldvalue(continued)Ifearningsgrowthisfactoredin,thevalueofHulseplcwillincreasesignificantly.Growthcanbeincludedbyadaptingthedividendgrowthmodel.Hulseearningsyieldvalue(includinggrowth) =(45.29m×1.02)=￡862m (0.0736–0.02)Price/earningsratiovaluationValueoffirm=P/Eratio×EPSoftargetfirmProblemhereiswhichP/Eratiotouse.HulseplcvalueusingtargetfirmP/Eratio: 13.59×45.29m=￡615m.Ifacquirerthinkstargetcompanyperformancewillbesimilartoitsown,itcanuseitsownP/Eratio.ValueofHulseplcusingCommons’P/Eratio: 18.2×45.29m=￡824m.Price/earningsratiovaluation(continued)Ifperformanceofneitherfirmwillchange,wecoulduseweighted-averageP/Eratio:[(13.59×45.29)+(18.2×120)]/165.29=16.93ValueofHulse=16.93×45.29m=￡767mInadditiontoP/Eratioselectionproblem,itisdifficulttoestimatefutureearningsandtheirexpectedgrowth.DividendgrowthmodelValueisPVofexpectedfuturedividends

P0=D0

(1+g) (r

g)

P0= currentshareprice

D0= currentdividend

g = expecteddividendgrowthrate

r= thecostofequityDividendgrowthmodel(continued)HulseplcFromhistoricaldividends:10.5×(1+g)4=12 Henceg=(12/10.5)0.25

1=0.0339(3.39%)CostofequityoftargetfirmusingtheCAPM: 4.5+[1.17×(9.5

4.5)]=10.35%Totaldividend=0.12×246m=￡29.52mApplyingthedividendgrowthmodel Hulsevalue=(29.52×1.0339)=￡439m (0.1035

0.0339)DCFvaluationDCFvalueoftarget=PVofincrementalcashflowsgainedbyacquirer Problems:DifficulttoquantifyexpectedbenefitsfromoperatingandfinancialsynergiesDifficulttochooseappropriatetimehorizonandterminalvaluefortargetWhichdiscountrateshouldbeused?DCFvaluation(continued)HulseplcCurrentcashflows=￡38mCashflowgrowthrate=4%peryearWACCofCommonsplc=7%peryearSurplusassetssoldintwoyears=￡60m

(38×1.04)= ￡1,317m(0.07

0.04) 60/1.072=

￡52m

DCFvalue= ￡1,370mFinancing:cashoffersAttractivetotargetcompany’sshareholdersbecause:Compensationtheyreceivefortheirsharesiscertaininvalue.Theyadjusttheirportfoliostosuit.Disadvantage:Sellersmaybeliabletopaycapitalgainstaxonsharessoldtobidder.Financing:cashoffers(continued)Advantagestobiddingcompany:Canseeexactlyhowmuchisbeingoffered.Noeffectonnumberofissuedshares.Amajorissueiswherethecashcomesfrom:Cashfromretainedearningsisusuallyinsufficienttobuytargetcompanyshares.Pre-bidrightsissuecouldbeused.Pre-bidbondissueorbankloanscouldbeused,butgearingandinterestratechangesmustbeconsidered.Financing–share-for-shareoffersTargetcompanyshareholdersareofferedafixednumberofsharesinthebidderinexchangefortheirshares. Advantagesfortargetcompanyshareholders:Retainequityinterestintheircompany.Nobrokeragecostsfromreinvestingcashandnocapitalgainstaxliability.Financing:share-for-shareoffers(continued)Disadvantagestoacquiringcompanyanditsshareholders:Moreexpensivethancashoffersasofferpricemustprotectagainstfallinmarketpriceofbiddingcompany’sshares.Increasesnumberofsharesincirculation.Shareissuemaymovebidderawayfromitsoptimalcapitalstructure.Financing:securitypackagesNon-equitysecuritiesthatcouldbeused:OrdinarybondsConvertiblebondsPreferencesharesForvariousreasons,thesearenolongerpopularfromapaymentpointofviewandsoarerarelyseeninpractice.Financing:mixedbidsMixedbidsarewhereashare-for-shareofferissupportedbyacashalternative.Theyhavebecomeanincreasinglypopularfinancingchoicebecause:theyareseenasbeingmoreacceptabletothetargetcompany’sshareholders.Rule9oftheCityCodeonTakeoversandMergersrequiresamixedbidwhen30%oftargetcompanysharesareheld.StrategicandpracticalissuesStrategicprocessofacquiringtargetcompany:IdentifysuitabletargetcompaniesObtaininformationonthesetargetsValueeachtargetcompanyanddecideonthemaximumpurchasepriceChoosemostappropriatepotentialtargetIdentifybestwaytofinancetheacquisitionSelecttacticslikelytomakebidsuccessfulMergerregulationandcontrolLegalcontrols:OftenreferredtoasantitrustregulationEnterpriseAct2002establishedOfficeofFairTradingtoreviewmergersandacquisitionsCompetitionandMarketsAuthority(CMA)replacedtheOFTin2014.Ifthereappearstobesubstantialreductionincompetition,transactionsmaybereferredtoCMA.AcquisitionmaybeinvestigatedifUKturnover>￡70mormarketshareofnewentity>25%InvestigationconsidersthepublicinterestMergerregulationandcontrol(continued)Publicinterestcriteria:MaintainingeffectivecompetitioninindustryInterestsofconsumers,purchasersandusersintermsofquality,priceandvarietyReducingcosts,introducingnewproducts

ortechniquesCMAinvestigationcantakeupto6months,duringwhichtimethebidisonholdEffectivenessofCMAisoftendebatedMergerregulationandcontrol(continued)Self-regulatorycontrols:CityPanelonTakeoverandMergersregulatestakeoverprocessviaCityCode.CityCodeobeyedbyallplcsandreflectsconceptofequitybetweenshareholders.CityCodeensuresshareholdersintakeoverprocesstreatedequally.Non-compliancecanresultincapitalmarketfacilitiesbeingwithdrawn.ThebiddingprocessCompaniesshouldhaveamaximumpriceabovewhichtheywillnotgo.Thisshouldincludeacontrolpremium.Historically,premiumsrangebetween30%and50%ofthepre-bidmarketprice.Thebidpriceshouldalsotakeintoaccountanytransactioncosts.Thebiddingprocess(continued)CityCodeprovisions:3%rule:mandatorynotificationoftargetfirmreducespossibilityof‘dawnraids’,but‘concertparties’arepermitted.Ifbiddergains30%stakeintarget,cashbidtoallshareholdersmustbemade.Oncebidderinformstargetboardofoffer,itmustbepassedtotargetshareholderswithin28days.Thebiddingprocess(continued)CityCodeprovisions:Offeristhenopenfor21days,althoughamendmentsmayextendperiodby14days.Anofferbecomesunconditionalwhenbidderacquiresmorethan50%oftarget’sshares.PartialbidsarerareandTakeoverPanelapprovalisneeded.BiddefencesDecisiontocontestabidshouldbemadeinthebestinterestsoftheshareholders.Constructivepre-biddefences:ImprovingoperationalefficiencyExaminingassetportfoliosandmakingnecessarydivestmentsEnsuringgoodinvestorrelationsBiddefences(continued)Obstructivepre-biddefences:Restructuringofequity:SharerepurchaseschemesPoisonpillsManagementretrenchmentdevices:GoldenparachutesStrategicdefenceviacross-holdingsBiddefences(continued)Post-biddefences:RejectionoftheinitialofferApre-emptivecirculationtoshareholdersFormulationofadefencedocumentProfitsannouncementsandforecastsDividendincreaseannouncementsRevaluationofnon-currentassetsSearchingforawhiteknightAcquisitionsanddivestmentsDivestmentReasonsfordivestment:ToraisecashtoeaseliquidityproblemToraisecashtoreducegearingToallowfirmstofocusoncoreactivitiesandperhapsgenerateeconomiesofscaleDivestedassetsmaybeworthmoreinthehandsofspecialistmanagersCrownjeweldefenceDivestmentstrategiesSell-off:Companysellsoffpartofitsoperationstoathirdparty,usuallyforcashSpin-offordemerger:ProratadistributionofsubsidiarysharestoparentshareholdersStructureoffirmchanges,butnoassetsaresoldandcontrolremainswithparentDivestmentstrategies(continued)Managementbuyout(MBO):PurchaseofpartorallofafirmbyincumbentmanagementReasonsforMBO:Cooperationofsubsidiary’smanagersSubsidiary'smanagersmaybelievetheycanturnaroundaloss-makingsituationSolutiontomarginalisationproblemDivestmentstrategies(continued)FinancingofMBOs:ComprehensivebusinessplanessentialMBOisusuallyfinancedbydebtandequityEquityfinance:ManagersprefercontrollingequitystakeVenturecapitalistsneedexitrouteDebtfinanceMezzaninefinanceDivestmentstrategies(continued)DifficultiesfacedbyMBOs:MBOwillneedtoreplaceservicespreviouslyprovidedbyparentDeterminingafairpricefortheMBOComplexMBOtaxandlegalaspectsMaintainingrelationshipswithcustomers

andsuppliersDivestmentstrategies(continued)DifficultiesfacedbyMBOs:CanMBOgenerateanyadditionalfundsneededtorefurbishorreplacefixedassets?MBOmustconsiderhowtomaintainpensionrightsofemployeesandmanagers.Changesinworkpracticeneededtoturnaroundperformancemayberesisted.PrivateequityBetween2003and2004,privateequitywerebehindonethirdofUKmergersandacq