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CHAPTER 30: MERGERS AND ACQUISITIONS

Topics:

• 30.1 Background

• 30.4-30.5 Synergy

• 30.6, 30.7, 30.9 NPV Analysis of Mergers

• 30.10 Defensive Tactics

• 30.11 Empirical Evidence

This set of slides is a brief introduction to Chapter 30.

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Background

• Merger: Companies A and B become one company (A+B) via an agreement which is – Negotiated between the firms’ boards

– Subsequently voted on by shareholders

– Company B receives some number of company A shares, plus also (perhaps) some cash.

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Background

• Acquisition: One company (or individual) A buys a controlling stake of company T.– Management/board approval not required– No shareholder meeting/vote required– Accomplished by tender offer: a public offer made to each

shareholder independently. May be cash, stock or some combination thereof.

• Tender offers are typically conditional.– E.g., if more than 50% of shareholders do not tender, then offer is

canceled.

• Usually the parties can be classified as: acquirer & target• In most cases, a substantial premium is paid• M&A activity has been quite extensive in the past two

decades.

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Types

• Friendly vs. hostile– Mergers are almost always considered friendly

– Acquisitions may be hostile: resisted by the target’s management and board.

• Cash vs. stock merger

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Common defensive tactics in Hostile acquisition • Supermajority agreements (approval of a specified majority

(usually 2/3 or ¾) of the acquired firm’s shareholders)

• Poison Pill Agreement (Shareholder rights plans)– Existing shareholders are given the right to acquire shares at half-

price.

– Acquirer’s rights are cancelled.

• Greenmail: payoff to acquirer to drop the bid

• Golden parachutes

• White knight

• Proxy contest: One group of shareholders attempt to gain controlling seats on the board by voting out the board of directors.

– A response to defensive tactics

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The Inco M & A case: The players• INCO

– Primary products: Nickle, 2005 sales: $4.5 billion US. Based in Toronto

• Falconbridge– Primary products: Copper and nickle, 2005 sales: $8.1 billion US. Based in

Toronto

• Xstrata – Copper, coking coal etc, 2005 Sales: $8 billion US. Based in Switzerland.

• Phelps Dodge Corp. – Primary products: copper, 2005 sales: $8.3 billion US. Based in Arizona

• Teck Cominco– Primary products: zinc, metallurgical coal, coper, 2005 sales: $4.4 billion

Cdn. Based in Vancouver

• Companhia Vale do Rio Doce (CVRD)– Largest global producer of iron ore and pellets. Based in Brazil.

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Case cont’d: From Hunter to Hunted

Oct. 2005: Inco announced a friendly takeover to buy Falconbridge for $12 billion

Xstrata submitted a hostile takeover bid for Falconbridge

May 2006: Teck Cominco submitted a hostile takeover bid to purchase Inco for $16 billion if it agreed to abandon its takeover of Falconbridge.

June 2006: Phelps Dodge submitted a friendly takeover to buy a combined Inco and Falconbridge for around $40 billion; offer withdrawn due to the failure of the Inco-Falconbridge merger.

August 2006: Brazilian mining company CVRD extended an all-cash offer to buy Inco for $17 billion. Now Inco becomes CVRD Inco.

The Xstrata bid was successful, but not before Falconbridge employed a poison pill to delay the acquisition, raising its share price from $28 to $62.50. (firm value:$23.8bn)

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Why merge?

• To justify a merger we need to show that

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

• If so, there are synergies:

Synergy = PV(A+B) – [PV(A) + PV(B)]

• NPV of merger to acquirer = Synergy – Premium

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Sources of synergy (see section 30.5)

• increased revenues

• reduced costs– Including replacing ineffective managers

• tax benefits– Net operating losses

– Unused debt capacity

• reduced cost of capital– Economies of scale

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Valuation of Synergy

• In principle, synergy can be determined using the standard DCF approach:

• In practice, it is difficult to determine synergy– it is hard to estimate incremental cash flows precisely

– discount rate – should reflect risk associated with use of funds

– there are also costs to consider (e.g. transaction costs)

T

1t tt

)r1(

CFsynergy

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How to pay for the target: Cash or stock?

• assuming that synergies have been calculated (i.e. the PV of the benefits of a merger), the next step is to assess the costs involved

• simple when cash is paid - the value of the merger to the acquiring firm is simply the synergies minus the PV of the costs

• with a stock offer, the costs depend on the gains because the post-merger stock price depends on the gains

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Example

Before a merger announcement:

Suppose that synergies have been determined to be $4,750,000 (due to cost savings)

Firm A Firm B Market price per share $75 $15 Number of shares 1,000,000 600,000 Market value of firm $75,000,000 $9,000,000

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Example cont’d: Cash offer

Cash offer: Assume that A will pay $12 million for B. Then the premium paid is $3 million and

NPVA =

However, this assumes that B’s current market price accurately reflects its value as a separate entity. What if takeover rumours have already increased B’s share price by $2?

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Example cont’d: Stock offer

• Suppose that A will offer 160,000 shares instead of $12 million cash. The apparent premium being paid is

• However, note that the total value after the merger is

• This means that the new share price will be:

so the real premium is

• How can the terms be set so that the premium is really $3 million?

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Cont’d: solution

Premium = 3m = Pnew x Nb – 9mα = % of merged firm owned by B’s S/Hα = B’s value/total firm value post merge =

= B’s shares/total shares =

NB =

Pnew =

Verify: Premium = 76.75 (156,352) – 9m = 3m

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Choice of cash or stock

• If A’s management believes its shares are undervalued by the market, then it will tend to prefer a cash offer.

• Conversely, if A’s management believes its shares are overvalued, it will tend to prefer a stock offer– B’s S/H will likely figure this out if A makes a stock offer

signal that A’s shares are overvalued B’s S/H will want better terms

– With a stock offer, B’s shareholders will share in any subsequent gains (if the merger ultimately proves to be very successful) and any subsequent losses (if it doesn’t).

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Empirical evidence• Do acquisitions help shareholders?

– most evidence suggests that shareholders of target firms gain substantially, but shareholders in bidder firms do not

– bidder firm results are lower for stock offers than cash offers

– on average, the combined market values of bidders and targets do increase around the time of merger announcements

– diversifying acquisitions had positive bidder returns in the 1960s, but negative returns since then

• Do defensive tactics help target shareholders?– evidence is mixed – on average, target stocks decline in value

but there are many exceptions• e.g. greenmail is most often viewed negatively, but if it is seen

as giving management more time to find a better offer, it can be viewed positively by investors.

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Who captures the value of synergy?

---Table 30.9 Stock Price Changes in Successful U.S. Corporate Takeovers

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Realities of M&A

• Warren Buffet:

“Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad's body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders… We've observed many kisses but very few miracles.”

• Buffet is right!– In practice, targets almost always capture synergies

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• Assigned problems: # 30.1, 5-6