MERGERS AND ACQUISITIONS

The Market for Corporate Control

M&A Activities

• Mergers • Takeovers• LBOs• Compensation• Spin-offs, etc.

Definitions• Corporate control -- the power to make

investment and financing decisions.• Corporate governance -- the role of

the Board of Directors, shareholder voting, proxy fights, etc. and the actions taken by shareholders to influence corporate decisions.

• Corporate structure -- the financial organization of the business.

Recent MergersIndustry Acquiring Company Selling Company

Payment ($billions)

Telecoms Vodafone (UK) Mannesmann (germany) 203.0

Pharmaceuticals Sanofi (France) Aventis (France/Germany) 64.0

Pharmaceuticals Pfizer Pharmacia 59.5

Banking JP Morgan Chase Bank One 58.0

Banking Bank of America FleetBoston Financial Corp. 49.3

Telecoms Cingular Wireless AT&T Wireless Services 41.0

BankingMitsubishi Tokyo Financial Group (Japan) UFJ Holdings (Japan) 25.7

Healthcare Anthem Wellpoint Health Networks 16.4

Insurance St. Paul Companies Travelers property Casualty 16.1

BankingBanco santander Central Hispano Abbey (UK) 15.6

Banking/Consumer Finance HSBC Holdings (UK) Household International 15.3

Media General ElectricVivendi Universal Entertainment (France) 13.7

Sensible Reasons for MergersEconomies of Scale

A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units.

$ $$Reduces costsReduces costs

Sensible Reasons for MergersEconomies of Scope or 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

Sensible Reasons for MergersCombining 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

Sensible Reasons for MergersCombining 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

Sensible Reasons for MergersMergers as a 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.

Dubious Reasons for Mergers• Diversification

– Investors should not pay a premium for diversification since they can do it themselves

• Empire Building• EPS Game

– EX: High PE firm buys Low PE firm -- resulting in higher EPS for merged firm (the bootstrap game)

Dubious Reasons for MergersThe Bootstrap Game

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.

Dubious Reasons for MergersThe Bootstrap Game

World Enterprises (before merger) Muck and Slurry

World Enterprises (after buying Muck

and Slurry)

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

Current earnings per dollar invested in stock (EP) 0.05$ 0.10$ 0.067$

Dubious Reasons for MergersEP Ratio

(log scale)

NowTime

.10

.067

.05

Muck & Slurry

World Enterprises (before merger)

World Enterprises (after merger)

Sensible Reasons for Mergers• Unused Tax

Shields• More Debt

Capacity– More Tax Shield– Lower BK Costs

Sensible Reasons for Mergers• Inefficient Management (Agency

Problems)• Management Controls

– Capital Markets (mergers, takeovers, LBOs)

• Other Managerial Controls– Board of Directors– Labor Markets (External & Internal)– Compensation Incentives (options)

Board of Directors

• Independent?• Monitoring• Hire/Fire• Compensation• Strategic Planning

Estimating Merger Gains

• Questions– Is there an overall economic gain to

the merger?– Do the terms of the merger make the

company and its shareholders better off?

PV(AB) > PV(A) + PV(B)

Estimating Merger Gains

• Economic Gain

Economic Gain = PV(increased earnings)

= New cash flows from synergies

discount rate

Example: Snowbird & AltaSnowbird is examining the purchase of Alta, which would become a subsidiary of Snowbird if the merger goes through. The projected cash flow statement for Alta(if merged) is shown on the next slide. These cash flows include all synergistic effects.Alta’s market-determined beta is 1.63. The risk-free rate is 10 percent and the market risk premium is 5 percent.

Alta has 10 million shares of stock priced at $6.25. Whatis the possible economic gain to this merger, if any?

Snowbird & AltaProjected Post-Merger Cash Flows for theAlta Subsidiary as of December 31

2002 2003 2004 2005 2006Net Sales 105.0$ 126.0$ 151.0$ 174.0$ 191.0$ Cost of Goods Sold (75.0) (89.0) (106.0) (122.0) (132.0) Selling and Admin. Expense (10.0) (12.0) (13.0) (15.0) (16.0) Depreciation (8.0) (8.0) (9.0) (9.0) (10.0) EBIT 12.0 17.0 23.0 28.0 33.0 Interest (8.0) (9.0) (10.0) (11.0) (11.0) EBT 4.0 8.0 13.0 17.0 22.0 Taxes (40%) (1.6) (3.2) (5.2) (6.8) (8.8) Net Income 2.4 4.8 7.8 10.2 13.2

Add Back Depreciation 8.0 8.0 9.0 9.0 10.0 Cash Flow from Operations 10.4 12.8 16.8 19.2 23.2 Less Retentions Need for Growth (4.0) (4.0) (7.0) (9.0) (12.0) Add TERMINAL VALUE 150.2 Net Cash Flow 6.4 8.8 9.8 10.2 161.4

Snowbird & AltaDiscount Rate

182.)05(.63.110.

)(

f

rmrfrr

Snowbird & AltaTerminal Value

Assume: terminal growth rate of 10%

2.15010.182.

)10.1)(0.122.23(

)1(20062007

2006

gr

gCF

gr

CFV

Snowbird & AltaTotal Firm Value

8.92$

5)182.1(

4.161$4)182.1(

2.10$

3)182.1(

8.9$2)182.1(

8.8$1)182.1(

4.6$2001

V

Snowbird & AltaPossibleEconomic Gain = Merger Value - Pre-merger Value

= $92.8 - $6.25 x 10,000,000

= $92.8 - $62.5

= $30.3 million

Snowbird & AltaChange in

Stockholders’

Wealth

Price Paid for Target$62.5 $92.8

Bargaining Range

= Synergy

Snowbird (Acquirer) Alta (Target)

Takeover MethodsTools Used To Acquire Companies

Proxy Contest

Acquisition

Leveraged Buy-Out

Management Buy-Out

Merger

Tender Offer

Takeover Defenses

White Knight - Friendly potential acquirer sought by a target company threatened by an unwelcome suitor.

Shark Repellent - Amendments to a company charter made to forestall takeover attempts.

Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.

Leveraged Buyouts

• The difference between leveraged buyouts and ordinary acquisitions:

1. A large fraction of the purchase price is debt financed.

2. The LBO goes private, and its share is no longer trade on the open market.

Leveraged Buyouts

• The three main characteristics of LBOs:

1. High debt2. Incentives3. Private ownership

Leveraged Buyouts10 Largest LBOs in 1980s and 1997/98 examples

Acquirer Target Industry YearValue ($mil)

KKR RJR Nabisco Food, tobacco 1989 24,720 KKR Beatrice Food 1986 6,250 KKR Safeway Supermarkets 1986 4,240 Thompson Co. Southland (7-11) Convenience stores 1987 4,000 KKR Owens-Illinios Glass 1987 4,680 Wings Holdings NWA, Inc. Airlines 1989 3,690 TF Investments Hospitals 1989 3,600 Macy Acquisitions Corp. Department stores 1986 3,500 Carlyle Group & Welsh, Carson, Anderson and Stowe Quest Dex Yellow pages 2002 7,050

Blackstone GroupTRW Automotive Holdings Auto parts 2002 4,700

KKR PanAmSat Satellites 2004 4,380 Texas Pacific group, Bain Capital. & Goldman Sachs. Burger King Fast food 2002 2,260

Phillips Petroleum CasePhilips balance sheet was dramatically changed by its leveraged restructuring (figures in $billions).

1984 Balance Sheet (Before LBO)Net Working Capital (0.7) 5.1 DebtFixed Assets 12.4 6.6 EquityTotal assets 11.7 11.7 Total liabilities

1984 Balance Sheet (Before LBO)Net Working Capital (0.7) 5.1 DebtFixed Assets 12.4 6.6 EquityTotal assets 11.7 11.7 Total liabilities

1985 Balance Sheet (After LBO)Net Working Capital 0.0 9.3 DebtFixed Assets 10.9 1.6 EquityTotal assets 10.9 10.9 Total liabilities

1985 Balance Sheet (After LBO)Net Working Capital 0.0 9.3 DebtFixed Assets 10.9 1.6 EquityTotal assets 10.9 10.9 Total liabilities

Spin-offs, etc.

• Spin off -- debut independent company created by detaching part of a parent company's assets and operations.

• Carve-outs-- similar to spin offs, except that shares in the new company are not given to existing shareholders but sold in a public offering.

• Asset Sales-- the sale of the assets of a division to other firms .

EXIT (Overcapacity)

1. Capital Markets2. Internal Control Mechanisms3. Regulation and Legal System4. Product and Factor Markets

• (Michael Jensen’s arguments)

Is M&A good or bad for economic efficiency?

Summary• M&A is Corporate Control Activity• Many Sensible Reasons for Mergers• Measure the Gains to Merger

– New cash flows from synergies– Discount rate– DCF Analysis

• Other M&A Activities• The Role of M&A Activity for the Economy