Mergers & takeovers (acquisitions)

• Merger:

Combination of two separate entity & creation of one reporting

entity

• Take over:

The acquisition of controlling interest in the voting share capital

of another company

Mergers and acquisitions involve many issues, including

• Corporate governance.

• Form of payment.

• Legal issues.

• Contractual issues.

• Regulatory approval.

Reasons for mergers & acquisitions• Main Reason: Synergy

Where present value of the combines enterprise is greaterthan the sum of present value of the individual companies

i.e 2+2=5

Synergy= VAB- ( VA+VB)

Because combined entity results provide better return that wasbeing achieved as by the same resources used in twoseparate companies

Type of synergies

– Operating

– Financial

– Other effects

SYNERGY

• Suppose Firm A is contemplating acquiring Firm B. The acquisition will be

beneficial if the

• combined firm will have greater value than the sum of the values of the

separate fi rms. If

• we let VAB stand for the value of the merged firm, then the merger makes

sense only if:

• V AB > V A + VB

• Where V A and V B are the separate values. A successful merger thus

requires that the value of the whole exceed the sum of the parts.

• The difference between the value of the combined firm and the sum of the

values of the firms as separate entities is the incremental net gain from the

acquisition, V = VAB - (VA + VB) When V is positive, the acquisition is said to

generate synergy .

Example for synergy

• Suppose that the “A” Company has made an offer for the “B”

Company that consists of the purchase of 1 million shares at $20

per share. The value of “B” Company stock before the bid was

made public was $15 per share. “A” Company stock is trading at $40

per share, and there are 10 million shares outstanding. “A”

Company estimates that it is likely to reduce costs through

economics of scale with this merger of $3 million per year, forever.

The appropriate discount rate for these gains is 10%.

• What are the synergistic gains from this merger?

TYPES of SYNERGIES

Revenue Synergy

• This is the first of the three types of synergy in mergers

and acquisitions. If two companies go through revenue

synergy, they happen to sell more products.

• For example, let’s say that G Inc. has acquired P Inc. G

Inc. has been in a business of selling old laptops. P Inc. is

not a direct competitor of G Inc. But P Inc. sells new

laptops quite cheap. P Inc. is still very small in profit and

size, but they have been giving a great competition to G

Inc. since it is selling new laptops in much lesser price.

Cost Synergy

• Cost synergy allows two companies to reduce costs as a result of the merger or the acquisition.

• Cost reduction is one of the most important

benefits of cost synergy. In the case cost

synergy, the rate of revenue may not increase;

but the costs would definitely get reduced. In this

example, when the cost synergy happens

between G Inc. and P Inc., the combined

company is able to save a lot of costs on

logistics, storage, marketing expenses, training

expenses

Financial Synergy

• Financial synergy is when two mid-sized companies

merge together to create financial advantages

• By going for financial synergy, these two companies not

only achieve financial advantages in the case of

borrowing loans or paying less interest but they also are

able to achieve additional tax benefits. Plus, they are

also able to increase their debt capacity and to reduce

the combined cost of capital.

Other reasons

• Diversification

• Revenue Enhancement

• Cost Reductions

• Tax Savings

• Reductions in capital needs

• Bootstrapping earnings

• Finance & liquidity

• Asset backing

• Growth

• Defensive merger

Bootstrapping earnings

• Bootstrapping earnings is the increase in earnings per share as a result of a

merger, combined with the market’s use of the pre-merger P/E to value post-

merger EPS.

• i. e: Company “ One” offers 1 share for each 2 shares of Company “ Two”

• If Market applies pre-merger P/E of Company One to post-merger

earnings.

Factors need to consider in a takeover decision

1. Price Factor

• Cost of the acquisition

• Whether acquisition worth for price

• How to determine the value of the businessEarnings

Assets

prospects sales & growth

How it would contribute to the strategy of the predator company

2. Other Factors• Whether takeover desirable by the predator companies shareholders

• Are the target company amenable to the takeover

• Form of the purchase consideration take

• How would takeover be reflected in public accounts

• Any other potential problems

Basic form of acquisitions-

Purchase of Shares of the target company

Shareholders shares target company simply be bought back

Example

“A” company is going to acquire “ B” Company for $400Mn Cash

Determine the takeover is worth for “ A” Ltd

" A" " B"

$ $

Book Value of Net assets 1,500Mn 200Mn

No of shares 100Mn 10Mn

Earnings 2,000Mn 40Mn

Share Exchange

Acquiring company will issuing shares to the target company

1. “ A” Company will acquire “ B” company & A will issue shares to B Company shareholders in exchange of their shares

2. Raise cash on the share market & used it to by shares of the target company shares

• Example 01

• “A Ltd is going to acquire “ B” Ltd. “ B” agree for share for

share exchange & “ B” Share holders will receive 25%

premium on their current market price

• Determine the number of new shares issued to “ B” Ltd

" A" " B"

No of shares 40Mn 10Mn

Earnings 60Mn 10Mn

P/E Ratio 10 12

Example of a merger:AMR and U.S. Airways

• U.S. Airways proposes merger to bankrupt AMR.

April 2012

• AMR creditors encourage AMR to merge with another airline, instead of emerging from bankruptcy alone.

July 2012

• AMR and U.S. Airways begin merger discussions.

September 2012

• U.S. Airways proposes merger, with its shareholders owning 30% of the new company.

November 2012

• Details of the merger are worked out.

• Merger filed with the FTC under Hart-Scott-RodinoAct.

February 2013

Copyright © 2013 CFA Institute 19

• Example 02

• “A Ltd is going to acquire “ B” Ltd. “ B” agree for share for share

exchange. The market price of shares are regarded as accurate

reflection of their intrinsic value. The takeover expected to have cost

saving which have present value of 12million.

• Bid offer: one share of “ A” for every thee shares of “ B”

• Calculate the wealth of the shareholder who owns 1000 shares

" A" " B"

No of shares 20Mn 6Mn

Earnings 10.00 3.00

P/E Ratio 10 12

• Example 03

• “A” Plc & “ B” Plc are listed companies

" A" Plc " B" Plc

Profit after tax 2.75Mn 2.4Mn

No of shares 10M 5Mn

PE Ratio 12 10

Bid: 5 New shares in " A" for every 3 shares in "B"

Calculate premium % price offered to " B"

• The acquiring firm shareholders want to minimize the amount paid to target

shareholders, not paying more than the pre-merger value of the target plus

the value of the synergies.

• The target shareholders want to maximize the gain, accepting nothing

below the pre-merger market value

Evaluating Bidder

Evaluating Formula

Target shareholders’ gain = Premium = PT – VT (10-7)

where

PT = price paid for the target company

VT = pre-merger value of the target company

Acquirer’s gain = Synergies – Premium = S – (PT – VT) (10-8)

where

S = synergies created by the business combination

VA* = VA + VT + S – C (10-9)

where

VA* = post-merger value of the combined companies

VA = pre-merger value of the acquirer

C = cash paid to target shareholders

i.e

Suppose that the “A” Company has made an offer for the “B”

Company that consists of the purchase of 1 million shares at Rs 20 per

share. The value of “B” Company stock before the bid was made

public was Rs 15 per share. “A” Company stock is trading at Rs.40 per

share, and there are 10 million shares outstanding. “A” Company

estimates that it is likely to reduce costs through economics of scale

with this merger of Rs.3 million per year, forever. The appropriate

discount rate for these gains is 12%.

1. What are the synergistic gains from this merger?

2. What parties, if any, share in these gains?

3. What is the estimated value of the “A” Company post-merger?

• “A Company Going o give offer for “B””

• 1. Pay 12.5 per share of “B”Ltd

• 2. Exchange 25 cash & one share of “A” for every 4 shares of “B”

• 3. exchange every 1 share of “A” for every 2 shares of ”B”

• What is the EPS under three plans

• Determine the MPS of “A”P/E ratio prevail

Company Sharesoutstanding

MPS Earnings

A 1,000,000 25 2,000,000

B 100,000 10 200,000

• “A ”wishes to give offer to “B” Ltd

• Mkt value of both companies reflect accurate reflection

• Take over expect synergy benefit of 1.5Mn every year forever. Required rate of return of share holders is 12.5%

• The bid consist of one share of” A for every 3 shares of B plus Rs 1 in cash for every three shares

• How much wealth of shareholder who owns 3000 shares of B would increase because of takeover successful

Company No of shares MPS

A 20Mn Rs.10

B 6Mn Rs.3