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Chapter 23

Chapter 23 ECON 2560

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University of Guelph
ECON 2560
Tahsin Mehdi

Chapter 23 ECON 2560 Mergers, Acquisitions, & Corporate Control SENSIBLE MOTIVES FOR MERGERS  In a normal business purchase, a business(the buyer) purchases equity (shares) from another business (the seller/target) and the buyer becomes a majority shareholder of the seller  Sometimes buyer gives cash  Sometimes buyer gives shares of its company in exchange for shares of the seller  Acquisition = When company buys most , if not all, of the target company’s shares in order to assume control of the target firm Merger: Acquisition of control of a business by another business  What happens after acquisition depends on nature of buyer and seller & terms of deal  Buyer and seller firms continue to operate as separate business that are commonly controlled  Sometimes assets & liabilities agree combined to create new company  Sometimes just 1 company continues to exist but includes all assets & liabilities of the other company so that it doesn’t exist anymore Mergers are categorized as horizontal, vertical or conglomerate… Horizontal Merger: Takes place between 2 firms in the same line of business. The businesses are former competitors  The assets & liabilities of acquired company are combined w/ assets and liabilities of the buyer to create 1 company  BUT the acquired company can continue to exist but becomes a subsidiary of the buyer Vertical Merger: Involves companies at different stages of production  The buyer expands back toward the source of raw materials or forward in the direction of the ultimate consumer  E.g. A soft-drink manufacturer buys a sugar producer expanding backwards  E.g. A soft-drink manufacturer buyer a fast food chain as outlet for product is expanding forward Conglomerate Merger: Involves companies in unrelated lines of business  Many mergers are motivated by the possible gains in efficiency from combining operations through synergy Synergy: The principle by which the value generated by the combination of companies is greater than the sum of their individual values Synergy = VAB – (VA+ VB) VAB = Merger VA = Company A V B = Company B  Many mergers that seem to make sense will fail b/c management can’t handle the complex task of integrating 2 firms w/ different production processes, accounting methods & corporate cultures  The value of most businesses depends on human assets – managers, skilled workers, scientists & engineers  If these people aren’t happy in their new roles most of them will leave Some possible sources of synergy… Increased Revenues  Mergers are often justified on the belief that revenues of the combined companies will exceed the sum of the revenues of the 2 companies run separately  BUT revenue synergies are hard to estimate b/c they are out of direct control of management  For revenues to increase, customer must buy more than they used to or be willing to pay a higher price & competitors must not lower their prices in response to the acquisition  Seemingly the most effective way to increase revenues is a horizontal merger  By combining w/ a competitor in the same business, market share & market power of the companies may increase allowing the merged company to raise prices w/ expectation of raising revenues  Society views that mergers lessen competition to the detriment of customers  Many companies have regulations dealing w/ mergers to have power to stop or demand modifications to mergers that are assessed to reduce competition Economies of Scale  Managers hope that economies of scale, the opportunity to spread fixed costs across a larger volume of output, they will be more competitive  The effect is to create increased economies of scale w/ higher volume at the remaining branches and lower costs per transaction  Economies of scale are the natural goal of horizontal mergers  Economies of scale have been claimed in conglomerate mergers  These mergers have savings coming from sharing central services such as accounting, financial control & top-level management Economies of Vertical Integration  Large industrial companies commonly like to gain as much control and coordination as possible over the production process by expanding back towards the output of raw material & forward to the ultimate consumer  Can achieve this by merging w/ supplier or a customer  Carried to extremes, vertical integration is inefficient  Some people wrongly think that vertical integration with suppliers means you’ll pay less for materials  If you pay less, the supplier’s profits will fall  Gains from vertical integration are achieved through improved coordination and control of production  Vertical integration is now less popular due to advent of JIT inventory systems and computerized ordering systems that make it easier for a company to manage its supply chain without having to own its suppliers  Many companies finding it better to outsource activities Combining Complementary Resources  Many small firms are acquired by large firms that can provide the missing piece necessary for firm’s success  Small firm may have a unique product but lack the engineering and sales organization necessary to product & market it on a large scale  Firm could develop engineering and sales talent from scratch but it may be quicker & cheaper to merge w/ a firm that already has good talent  The 2 firms have complementary resources – each has what other needs – so it makes sense for merge Merging to Reduce Taxes  The tax implications of a merger or acquisition are often very complex  It may be possible to reduce the total taxes of the combined companies if 1 of the companies has tax shields its unable to use  E.g. If a company w/ operating losses merger w/ a company in the same business that has taxable income, the losses may be vulnerable to tax deduction  Merging for the sole purpose of using operating losses is not permitted & CRA may disallow the tax deductions  Unused interest tax shields are another merger motive  The interest on debt generate an interest tax shield  A company w/ unused debt capacity, perhaps due to poor management, may be an attractive target  The acquirer will increase the target’s debt/equity ratio, taking advantage of the interest deduction to reduce taxes & increase target firm value Mergers as a Use for Surplus Funds  If firm isn’t willing to purchase its own shares, it can instead purchase someone else’s  Firms w/ a surplus of cash & shortage of goo investment opportunities often turn to mergers financed by cash as a way of deploying their capital  Also avoids the tax consequences of dividends & share repurchases  Firms that have excess cash & don’t pay it out or re-deploy it by acquisition often find themselves targets for takeover by other firms that propose to re-deploy the cash for them DUBIOUS REASONS FOR MERGERS Diversification  Managers of cash rich companies may prefer to see that cash used for acquisitions  We often see cash-rich firms in stagnant industries merging their way into fresh companies  Diversification reduces risk  Argument that diversification is easier and cheaper for the shareholder than for the corporation The Bootstrap Game  Bootstrap game is say you manage a company that has a high price-earnings ratio. The reason its high is b/c investors anticipate rapid growth in future earnings. You achieve this growth not by capital investment, product improvements or increased operating efficiency but by purchasing slow-growing firms w/ low price-earnings ratios  The long run result will be slower growth and a depres3ed price-earnings ratio but in the short run earnings per share can increase dramatically  If this fools investors you may be able to achieve the higher earnings per share without suffering a decline in your price-earnings ratio  In order to keep fooling investors, you must continue to expand by merger at the same compound rate  Can’t do this forever… one day expansion will slow or stop  Earnings growth will cease THE MECHANICS OF A MERGER The Form of Acquisition 3 Ways 1 firm can acquire another firm… 1. Amalgamate  The combination of the assets & liabilities of 2 firms into 1 (called merger in the US)  Laws governing amalgamations found both in federal & provincial business corporation acts  Laws such as “plan of arrangement” & “statutory amalgamation” provide the procedure for combining the assets & liabilities of 2 companies  For amalgamation to succeed in Canada, a large majority of shareholders has to approve it by voting in favour at a special shareholders’ meeting, at least 66 2/3 % of votes  The % shareholder approval for a US merger can be as low as 50% but it might be higher depending on the relevant state laws & the company’s corporate charter  In an acquisition by amalgamation deal, the board of directors of both companies meet to agree on the terms of the deal& then must get shareholders to approve the deal  In some amalgamations an acquiring company takes all the assets & the liabilities of the target company which ceases to exist  Former shareholders of the target firm receive cash and/or securities in the acquiring firm  BUT sometimes an entirely new company is created through amalgamation and both original companies disappear 2. Purchase a majority of shares  The offer to purchase stock = takeover bid in Canada and Tender Offer in the US  By offering to buy shares directly from shareholders, the acquiring firm can bypass the target firm’s management & board of directors  Whenever a takeover bid is made, board of director tells target firm shareholders whether they approve of the bid or not  A takeover bid is friendly if management & board of directors of the target company are in favor of offer  If they don’t, than its called a hostile takeover bid  If takeover bid is successful, the buyer obtains enough shares to control the target and can, if it chooses, toss out the current management  Many takeover bids are conditional on acquiring a minimum of 2/3 of the outstanding shares  2/3 ensures it will win the subsequent vote to approve the amalgamation of the target company with the acquired 3. Purchase its assets  In this case ownership of the assets is transferred & payment is made to the selling firm rather than directly to its shareholders  Usually the target firm sells only some of its assets but sometimes all  If sells all, the selling firm continues to exist as a independent entity but becomes an empty shell – engaged in no business activity Mergers, Antitrust Law & Popular Opposition  Any business may be blocked by government if its assessed as likely to substantially increase the market power of the merged firms and so to result in prevention or lessening of competition  Canada the Competition Act prohibits mergers that severely limit competition  Merger proposals are rarely turned down for anti-competitive reasons in Canada  Mergers between companies w/ global operations may require approval in various countries  Mergers may also be foiled by political pressure & popular resentment even when no formal antitrust issues arise EVALUATING MERGERS When evaluation a proposed merger must consider 1. Is there an overall economic gain to the merger? 2. Do the terms of the merger make my company & its shareholder better off? Mergers Financed by Cash Question #1: Would the 2 companies be worth more together or apart? Economic gain = PV (increased Earnings) x increased earnings from combining cost of capital percent (as decimal)  This additional value is the basic motivation of the merger  Next step is to determine how the economic gain of the merger is divided between shareholders of the 2 companies which is determined by the terms of the merger Question #2: What are the terms of the merger? What is the cost to each company and their shareholders?  Management & shareholders of the target firm wont consent to merger unless they r
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