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Mergers & AcquisitionsMergers & Acquisitions

FINC 446 Financial Decision MakingFINC 446 Financial Decision Making

Dr. Olgun Fuat SahinDr. Olgun Fuat Sahin

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Mergers and AcquisitionsMergers and Acquisitions

• Vertical merger: forward or backward Vertical merger: forward or backward integrationintegration

• Horizontal merger: expansion in a particular Horizontal merger: expansion in a particular business linebusiness line

• Conglomerate merger: combination of Conglomerate merger: combination of companies from unrelated business lines companies from unrelated business lines

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Value Related Reasons for M&AValue Related Reasons for M&A

• SynergismSynergism

• TaxesTaxes

• Information AsymmetryInformation Asymmetry

• Agency CostsAgency Costs

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SynergismSynergism

• Synergism: Whole is worth more than sum of its parts Synergism: Whole is worth more than sum of its parts (M&A math is 2 + 2 = 5)(M&A math is 2 + 2 = 5)– Economies of scale – lower costs by combining operationsEconomies of scale – lower costs by combining operations

• Using excess capacityUsing excess capacity

• Spreading fixed costs over larger volumeSpreading fixed costs over larger volume

– Economies of scope – can carry out more activities Economies of scope – can carry out more activities profitablyprofitably

• Producing similar productsProducing similar products

• Backward integration – buying a supplier to reduce costsBackward integration – buying a supplier to reduce costs

• Forward integration – moving control one step closer to customersForward integration – moving control one step closer to customers

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Synergism (Continued)Synergism (Continued)

– Economies of financing – larger companies can Economies of financing – larger companies can raise money more economicallyraise money more economically• The more money raised, the lower the issuance costs on The more money raised, the lower the issuance costs on

a per dollar raiseda per dollar raised

• Higher liquidity for the securities reducing cost of Higher liquidity for the securities reducing cost of issuance to the firmissuance to the firm

– Risk reduction – lower unsystematic risk will Risk reduction – lower unsystematic risk will reduce expected bankruptcy costsreduce expected bankruptcy costs

– Market power – larger market share allows control Market power – larger market share allows control over priceover price

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TaxesTaxes• A merger can reduce the tax of a combined firm A merger can reduce the tax of a combined firm

because:because:1.1. The acquirer has large cash flows with limited opportunities – The acquirer has large cash flows with limited opportunities –

returning cash to shareholders exposes them to taxesreturning cash to shareholders exposes them to taxes

2.2. Revaluing assets of the target can create depreciation expense Revaluing assets of the target can create depreciation expense for tax purposesfor tax purposes

3.3. Losses of a target that have been carried forward can be used Losses of a target that have been carried forward can be used by the combined firmby the combined firm

4.4. Alternative Minimum Tax might encourage acquisitions by Alternative Minimum Tax might encourage acquisitions by reducing overall tax payment for firms if they are combinedreducing overall tax payment for firms if they are combined

5.5. Diversification through M&A can increase debt capacity Diversification through M&A can increase debt capacity increasing tax shieldincreasing tax shield

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Information AsymmetryInformation Asymmetry

• Acquiring company posses information that is Acquiring company posses information that is not available to the investorsnot available to the investors

• Buying another company implies that the Buying another company implies that the acquiring firm managers have found a acquiring firm managers have found a “bargain” “bargain”

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Agency CostsAgency Costs

• M&A allows inefficient managers to be M&A allows inefficient managers to be replacedreplaced

• Activities in the takeover market curb the Activities in the takeover market curb the agency costagency cost

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Management Related Reasons for Management Related Reasons for MergersMergers

• Reduction of Unsystematic RiskReduction of Unsystematic Risk

• Takeover RiskTakeover Risk

• Size PreferenceSize Preference

• Hubris HypothesisHubris Hypothesis

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Reduction of Unsystematic RiskReduction of Unsystematic Risk

• Diversification at the firm level will reduce the Diversification at the firm level will reduce the unsystematic riskunsystematic risk– Previously this was good because lower Previously this was good because lower

unsystematic risk reduces expected bankruptcy unsystematic risk reduces expected bankruptcy costscosts

– Managers also benefit form lower unsystematic Managers also benefit form lower unsystematic risk because lower variability in earnings increases risk because lower variability in earnings increases job security and stabilizes compensationjob security and stabilizes compensation

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Takeover RiskTakeover Risk

• If a company is target for a proposed If a company is target for a proposed acquisition then the target can make it difficult acquisition then the target can make it difficult by acquiring another – hard to swallowby acquiring another – hard to swallow

• A defensive acquisition can create a regulatory A defensive acquisition can create a regulatory hurdle for the original suitor as wellhurdle for the original suitor as well

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Size PreferenceSize Preference

• Managers’ self fulfilling prophecies – bigger is Managers’ self fulfilling prophecies – bigger is better not necessarily profitablebetter not necessarily profitable

• Larger firm can provide more compensation Larger firm can provide more compensation for managersfor managers

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Hubris HypothesisHubris Hypothesis

• Hubris hypothesis suggest that acquiring firm Hubris hypothesis suggest that acquiring firm managers rely too much on their abilities to managers rely too much on their abilities to identify, undertake, and manage potential identify, undertake, and manage potential targetstargets

• Usual outcome of such acquisitions is a Usual outcome of such acquisitions is a disaster admitted by divestituresdisaster admitted by divestitures

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M&A ProcessM&A Process

• Identify a TargetIdentify a Target

• ValuationValuation

• Mode of AcquisitionMode of Acquisition

• Mode of PaymentMode of Payment

• Accounting of AcquisitionAccounting of Acquisition– Note: Regulators (Federal Trade Commission – Note: Regulators (Federal Trade Commission –

FTC) can block a deal or require substantial asset FTC) can block a deal or require substantial asset sell offsell off

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M&A Process (Continued)M&A Process (Continued)• Identify a Target:Identify a Target:

– Based on a sound strategy that can increase Based on a sound strategy that can increase shareholders’ wealthshareholders’ wealth

– Focus on “Value Related Reasons”Focus on “Value Related Reasons”

– Acquisitions are usually initiated by the acquiring Acquisitions are usually initiated by the acquiring firmfirm

– Sometimes a target can announce that it is for saleSometimes a target can announce that it is for sale

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M&A Process (Continued)M&A Process (Continued)• Valuation:Valuation:• Net Cash Flow: Net Cash Flow:

EBIT x (1 – tax rate)EBIT x (1 – tax rate)+ depreciation and other non-cash expenses+ depreciation and other non-cash expenses– – acquisition of new assetsacquisition of new assets+ increases in liabilities other than LTD+ increases in liabilities other than LTD= Net cash flow= Net cash flow

• Equity Residual Cash Flow:Equity Residual Cash Flow:Net IncomeNet Income – – preferred dividendspreferred dividends+ depreciation and other non-cash expenses+ depreciation and other non-cash expenses – – acquisition of new assetsacquisition of new assets+ increases (– decreases) in liabilities+ increases (– decreases) in liabilities+ increases (– decreases) in preferred stocks+ increases (– decreases) in preferred stocks= Equity residual cash flow= Equity residual cash flow

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M&A Process (Continued)M&A Process (Continued)

• Valuation:Valuation:– Should not ignore the value of strategic options and Should not ignore the value of strategic options and

payment termspayment terms

– In general an acquisition creates wealth for the In general an acquisition creates wealth for the acquirer if:acquirer if:

[Target [Target AloneAlone + Synergies + Other] + Synergies + Other]

>= >=

[Cash Paid + Stock Paid + Debt Assumed][Cash Paid + Stock Paid + Debt Assumed]

What Acquirer Gets

What Acquirer Gives

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M&A Process (Continued)M&A Process (Continued)• Mode of Acquisition:Mode of Acquisition:

– Refers to whether a proposed acquisition is friendly or hostile to Refers to whether a proposed acquisition is friendly or hostile to target target managersmanagers

• Friendly acquisitions are approved by board of directors Friendly acquisitions are approved by board of directors of each firmof each firm

• Then shareholders vote on the proposalThen shareholders vote on the proposal• If no negotiation possibility exists then an acquirer can If no negotiation possibility exists then an acquirer can

proceed with a tender offer to target shareholders – proceed with a tender offer to target shareholders – making it hostilemaking it hostile

• Hostile takeover can be quite time consuming especially Hostile takeover can be quite time consuming especially when target managers fight against the tender offerwhen target managers fight against the tender offer

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M&A Process (Continued)M&A Process (Continued)

• Mode of Payment:Mode of Payment:– How an acquisition is paid for: cash, stock or How an acquisition is paid for: cash, stock or

mixedmixed

• If the stock is believed to be undervalued, then If the stock is believed to be undervalued, then stock should not be used for paymentstock should not be used for payment

• If the stock is overvalued then the stock If the stock is overvalued then the stock payment should/can be usedpayment should/can be used

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Takeover DefenseTakeover Defense• Golden parachuteGolden parachute

– A contract designed to give executives substantial A contract designed to give executives substantial compensation if they are dismissed following a compensation if they are dismissed following a takeover takeover

• Poison pills, flip-over rights allowing holders Poison pills, flip-over rights allowing holders to receive stock in the acquirer if the bidder to receive stock in the acquirer if the bidder acquires 100% of the targetacquires 100% of the target

• Poison pills, flip-in rights allowing holders to Poison pills, flip-in rights allowing holders to receive stock in the targetreceive stock in the target– It is effective against raiders who seek to acquire It is effective against raiders who seek to acquire

controlling interestcontrolling interest

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Takeover Defense (Continued)Takeover Defense (Continued)

• Poison putsPoison puts– Bond issues that become due if unfriendly Bond issues that become due if unfriendly

takeover occurstakeover occurs

• GreenmailGreenmail– Managers of target buys shares purchased by Managers of target buys shares purchased by

acquirer at a substantial premiumacquirer at a substantial premium

• White knightWhite knight– A third company acquiring the target with friendly A third company acquiring the target with friendly

terms terms

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Accounting MethodAccounting Method

• There used to be two methods: Pooling of There used to be two methods: Pooling of Interest and Purchase method for acquisitionsInterest and Purchase method for acquisitions

• Pooling of Interest:Pooling of Interest:– It can be used if payment is made in the form of It can be used if payment is made in the form of

acquirer’s stockacquirer’s stock

– Balance sheet and income statement of the Balance sheet and income statement of the combined company are generated by adding up combined company are generated by adding up itemsitems

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Accounting Method (Continued)Accounting Method (Continued)• Purchase method: Purchase method:

– Balance sheet of the combined entity is constructed as follows: Balance sheet of the combined entity is constructed as follows: If the price paid is same as the net asset value (book value – If the price paid is same as the net asset value (book value – total liabilities), balance sheet of the combined company is total liabilities), balance sheet of the combined company is generated by adding up itemsgenerated by adding up items

– If the price paid is less than the net asset value, the assets are If the price paid is less than the net asset value, the assets are written down written down

– If the price paid is more than the net asset value, the assets are If the price paid is more than the net asset value, the assets are appraised. If the price is still more than appraised value of net appraised. If the price is still more than appraised value of net assets, the difference is an asset called goodwillassets, the difference is an asset called goodwill

– The income statement reflect the depreciation expenses The income statement reflect the depreciation expenses adjusted for the revaluationadjusted for the revaluation

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Accounting for GoodwillAccounting for Goodwill• The Financial Accounting Standards Board (FASB) The Financial Accounting Standards Board (FASB)

issued two statements changing all that:issued two statements changing all that:• FASB Statement No. 141 Business CombinationsFASB Statement No. 141 Business Combinations

– Requires the purchase method of accounting be used for all Requires the purchase method of accounting be used for all business combinations initiated after June 30, 2001business combinations initiated after June 30, 2001

• FASB Statement No. 142 Goodwill and Other Intangible FASB Statement No. 142 Goodwill and Other Intangible AssetsAssets– Changes the accounting for goodwill from an amortization Changes the accounting for goodwill from an amortization

method to an impairment-only approachmethod to an impairment-only approach– ““Goodwill will be tested for impairment at least annually using Goodwill will be tested for impairment at least annually using

a two-step process that begins with an estimation of the fair a two-step process that begins with an estimation of the fair value of a reporting unit. The first step is a screen for potential value of a reporting unit. The first step is a screen for potential impairment, and the second step measures the amount of impairment, and the second step measures the amount of impairment, if any.”impairment, if any.”

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Target and Acquirer Performance Target and Acquirer Performance around Announcementaround Announcement

• Dodd (1980), “Merger proposals, management discretion Dodd (1980), “Merger proposals, management discretion and stockholder wealth,” Journal of Financial Economics, and stockholder wealth,” Journal of Financial Economics, Volume 8, Issue 2, June 1980, Pages 105-137Volume 8, Issue 2, June 1980, Pages 105-137– 151 targets and 126 bidders over 1970-1977151 targets and 126 bidders over 1970-1977

BiddersBidders TargetsTargets

SuccessfulSuccessful

2-day AR *2-day AR * -1.09%-1.09% 13.41%13.41%

Sample SizeSample Size 6060 7171

T-statisticsT-statistics -3.0-3.0 23.823.8

UnsuccessfulUnsuccessful

2-day AR2-day AR -1.24%-1.24% 12.7312.73

Sample SizeSample Size 6666 8080

T-statisticsT-statistics -2.6-2.6 19.119.1

* AR is Abnormal Return = Actual – Expected. Reported AR is average of firm ARs.

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Target and Acquirer Performance Target and Acquirer Performance around Announcement (Continued)around Announcement (Continued)

• Bradley, Desai & Kim (1988), “Synergistic gains from Bradley, Desai & Kim (1988), “Synergistic gains from corporate acquisitions and their division between the corporate acquisitions and their division between the stockholders of target and acquiring firms”, Journal of stockholders of target and acquiring firms”, Journal of Financial Economics, Volume 21, Issue 1, May 1988, Financial Economics, Volume 21, Issue 1, May 1988, Pages 3-40Pages 3-40– 3-day announcement abnormal return for 236 3-day announcement abnormal return for 236 successfulsuccessful tender tender

offers over 1963-1984offers over 1963-1984

Sample SizeSample Size BiddersBidders TargetsTargets

Total SampleTotal Sample 236236 0.00%0.00% 21.6%21.6%

Single BiddersSingle Bidders 163163 0.65%0.65% 22.0%22.0%

Multiple BiddersMultiple Bidders 7373 -1.45%-1.45% 20.8%20.8%

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Target and Acquirer Performance Target and Acquirer Performance around Announcement (Continued)around Announcement (Continued)

• Bradley, Desai & Kim (1983), “The gains to bidding Bradley, Desai & Kim (1983), “The gains to bidding firms from merger,” Journal of Financial Economics, firms from merger,” Journal of Financial Economics, Volume 11, Issues 1-4, April 1983, Pages 121-139Volume 11, Issues 1-4, April 1983, Pages 121-139– 353 targets: 241 successful, 112 unsuccessful353 targets: 241 successful, 112 unsuccessful

– 94 unsuccessful bidders94 unsuccessful bidders

– 1983-19801983-1980

Sample SizeSample Size TargetsTargets

Unsuccessful TargetsUnsuccessful Targets 112112 35.6%35.6%

Subsequently Taken OverSubsequently Taken Over 8686 39.1%39.1%

Not Subsequently Taken OverNot Subsequently Taken Over 2626 23.9%23.9%

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Acquirer Performance in the Long-RunAcquirer Performance in the Long-Run

• Long Run Abnormal Return = Long-Run Actual Long Run Abnormal Return = Long-Run Actual Return – Long-Run Expected ReturnReturn – Long-Run Expected Return

• Long-Run Event Studies are very sensitive to “Joint Long-Run Event Studies are very sensitive to “Joint Hypothesis Problem”Hypothesis Problem”– They test two hypothesesThey test two hypotheses

• There is no abnormal performance after acquisitions – NullThere is no abnormal performance after acquisitions – Null

• The method of risk adjustment (estimation of expected return) is The method of risk adjustment (estimation of expected return) is accurate. This is very important since we do not have an asset accurate. This is very important since we do not have an asset pricing model that can explain security returns wellpricing model that can explain security returns well

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Study Sample Expected Returns AR Calculation Major Results

Franks, Harris and Titman (1991)

399 acquisitions, January 1975-December 1984

(1) CRSP equal-weighted market index(2) CRSP value-weighted market index(3) Ten-factor model(4) Eight portfolio benchmark

Jensen’s α in event-time and calendar-time portfolios

Jensen’s α:Average Abnormal Returns are (1) -0.2, (2) 0.29, (3) -0.11, and (4) -0.11 per month over 36 months. (1) and (2) are significant.Calendar-time portfolios:(2) 0.37 per month and significant(4) does not detect any abnormal performance with sub-samples as well

Agrawal Jaffe, and Mandelker (1992)

1,164 acquisitions, January 1955-December 1987

(1) Beta and size(2) Returns Across Time and Securities (RATS) with size adjustment

CAAR, starting with AD

CAAR for (1) is -10.26 for (+1, +60) and significant. CAAR for model (2) is similar. No abnormal performance during Franks, Harris and Titman (1991) study period

Loderer and Martin (1992)

1,298 acquisitions, 1955-1986

Similar to RATS CAAR, starting with effective date (ED)

Abnormal Returns are negative and significant over 3 years after acquisitions but insignificant over 5 years

Loughran and Vijh (1997)

947 acquisitions, 1970-1989

Matching firm based on size and book-to-market

Buy-and-Hold Abnormal Return (BHAR) starting with ED

BHAR over five years is -6.5 and insignificant. Cash BHAR is 18.5 and insignificant and Equity BHAR is -25 and significant

Rau and Vermaelen (1998)

3,517 acquisitions, January 1980-December 1991

Size and book-to-market matching portfolios

CAAR, starting with CD

CAARs for mergers and tender offers are -4.04 and 8.85, respectively. Both figures are statistically significant

Mitchell and Stafford (2000)

2,193 acquisitions, 1958-1993

Size and book-to-market matching portfolios

BHAR and Calendar-Time Abnormal Return (CTAR)

BHAR is zero for all acquisitions after adjusting for cross-sectional dependence, CTAR is negative and significant for equity financed acquisitions.

Acquirer Performance in the Long-Run Acquirer Performance in the Long-Run (Continued)(Continued)