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6767 Merger Intro Lecture1

Mergers and Acquisitions: Concepts and Issues Dec. 2006. Merger - Combination of Two Firms of Which One survives. Acquisition always at a premium over market price.

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92 views

6767 Merger Intro Lecture1

Mergers and Acquisitions: Concepts and Issues Dec. 2006. Merger - Combination of Two Firms of Which One survives. Acquisition always at a premium over market price.

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api-3699305
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© Attribution Non-Commercial (BY-NC)
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Mergers & Acquisitions:

Concepts & Issues


Dec. 2006
DEFINATIONS
• MERGER
– Combination of Two Firms of Which One
Survives
• ACQUISITION
– Bidder Buys All or Majority of Stock. Target
Continues to Exist as Subsidiary or
Associate
DEFINATIONS
• HOLDING Co.
– Purchase Only a Part of the Target Stock

• ASSET SALE
– Only Assets Sold. Liabilities not Transferred
Gains From Merger
Value Creation
• A + B == AB

• V(A) + V(B) < V(AB)

• GAIN = V(AB) - [V(A) + V(B)] =


WEALTH CREATION
Value Creation
• Acquisition always at a premium over
market price

• Value Creation Must for Successful Merger

• A Merger that Fails to Provide Economic


Gain (Additional Value) Makes the Bidder
Vulnerable
Estimating Cost & Gains
• Gain = PVAB --(PVA + PVB) where PV
stands for true value
• If Gain is Positive There is an Economic
Justification for the Merger

• Cost of Acquiring Firm B = Cost of


Acquiring Firm B Minus the Value of B as
Separate Entity
Estimating Cost & Gains
• Cost = Cash Paid Out -- PVB

• NPV of Merger == Gain -- Cost


== PVAB -- (PVA + PVB)-(Cash-PVB)
== PVAB -- PVA - Cash
• One Should Go Ahead with Merger if NPV
is Positive
Example of Cost & Gains
• PVA == Rs. 100 mill.
• PVB == Rs. 50 mill.
• Gain == + Rs. 25 mill
• PVAB == Rs. 175 mill.
• If B is bought for Rs. 65 mill. Then
• Cost == Cash - PVB
• == 65 - 50 = Rs. 15 mill
• NPV == 25 - 15 = Rs. 10 mill
Example of Cost & Gains
• Thus Shareholders of the target Firm B
have Captured Rs. 15 mill of the Total gain
of Rs. 25 mill
• Bidding Firm Shareholders Gain is Rs. 10
mill. They Start with a Firm Worth Rs. 100
mill., Pay Rs. 65 mill in Cash to Acquire
Firm B, and End with Combined Firm
Value of Rs. 175 mill.
Cost & Gains
• Suppose the merger was unanticipated. The
announcement will cause the value of firm
B to rise from Rs. 50 mill to Rs. 65 mill.(30
% increase)
• If the market is able to correctly assess the
merger gain ( = Rs. 25 mill), market value
of firm A will rise from Rs. 100 mill to Rs.
110 mill (10% )
Cost & Gains
• Estimating Gains
* DCF Value of Target with Merger Benefits --
cash for Acquisition
* A Risky Method of Estimating Gains Since
Analyst Can make large Errors in
Estimating Value of Business
* Better to Start with MVA, and estimate the
changes in the cash flow due to Merger
Cost & Gains
• Firm A Firm B
• Market Price / Share Rs. 75 Rs. 15
• No. Of Shares 1,000,000 600,000
• Market Value of Firm Rs. 75 m Rs. 9 m
• A intends to acquire B for Rs. 12 mill
• Estimate Cost and gains
• If due to rumours, price of B share risen by Rs. 2
prior to A’s announcement -- Cost?, Gain??
Cost & Gains
• Cost == (cash- MVB) + (MVB - PVB)
• == (12 - 9) + ( 9 - 9) = Rs. 3 m

• If rumours raise price of B, true vale of B is only


Rs. 7.8 m

• Cost == (12 - 9) + ( 9 - 7.8) = Rs. 4.2 m

• If true value of B is more than Rs. 9 mill (market


undervalues B), cost would be negative
Cost & Gains
• Suppose A plans to offer 160,000 shares
instead of Rs. 12 m.

• Apparent Cost == 160,000 x 75 -- 9 m


• == Rs. 3 m
• Is this the true cost?? Are shares of A
correctly valued at Rs. 75?
Cost & Gains
• They were worth Rs. 75 before the merger
was announced. The Suppose the merger
provides cost savings worth Rs. Rs. 4.75 m

• Gain == PVA - (PVA + PVB)


• == 88.75 - (75 + 9) = 4.75
Cost & Gains
• Hence after the announcement, we can now
expect the market price of A’s share to be
PAB == 88750,000/1160,000 = Rs. 76.50

• Hence Cost == (160,000 x 76.5) - 9 m


• == Rs. 3,240,000 = Rs. 3.24 m
Motivation
• SYNERY
– Operating Synergy
• Economies of Scale
• Economies of Scope
– Operational Synergy Implies that Costs of
Operations is Lowered and Profit/Surplus
Increases Due to Synergy
Motivation Financial Synergy
• Financial Synergy
– Financial Synergy Arises from Lower Financial
Costs Faced by a Merged Firm
– This arises from lower cost of raising finance
(issue expenses and their EOS)
– Because of combined cash flows the debt of the
new entity is more secure as prob. of
bankruptcy declines
•
Motivation Financial Synergy
• Bond Holders Hence Gain
• Do Stock Holders Lose??

• Debt Co-Insurance
Motivation
• Market Power
• Horizontal Integration
– Leads to better control over the market and greater power
to fix prices and thwart competition

• Vertical Integration & Transaction Costs


– Must lower costs through integration or strategic posture
Motivation
• Improved Management
– Resource/Asset Infusion
– Downsizing
– Renegotiating Contracts
• Worker/Managers
• Creditors
• Government
Motivation
• Hubris of Managers

• Diversification
Strategic Motives
• Diversification
– Internal Development vs. Acquisition

• Acquisition
– Costs & Returns
– Strategic Objectives
GENERIC ENTRY
STRATEGIES
• INTERNAL DEVELOPMENT

• ACQUISITION

• JOINT VENTURE

• STRATEGIC ALLIANCE
INTERNAL DEVELOPMENT
• CREATES A NEW BUSINESS UNIT IN
THE INDUSTRY
– Faces Structural Entry Barriers
• (Five Forces Model for Analysis)
– Reaction of Incumbent Firms
• (Retaliation -- Severe or Mild)
INTERNAL DEVELOPMENT
• COST OF ENTRY
– Investment in Facilities (Capacity Creation)
– Cost of Distribution Network, Sales Force,
Brand, Advertising, Service
– Technology Costs
– Start up Costs
– Sourcing of Managers/Inputs
COST OF RETALIATION
• Lower Prices (Cost Structure)
• Increase in Marketing Cost
• Warranty Extension
• Longer Credit
• Effect of Entry on the Industry Demand -
Supply Cost Structure
EVALUATION OF ENTRY
DECISION
• Probability of Retaliation Higher if :
– Slow industry Growth
– Commodity Like Product
– High Fixed Costs
– High Industry Concentration
– Strategic Imp. Of Position to Incumbent
– Management Style & Ownership
Motivation
• Tax Benefits

– Not Automatic. Losses of the firm taken over


may not be allowed to be carried forward
– Reverse Merger -- India
Motivation
• Bootstrapping
– Sometimes, even without economic gains, a
merger can rising earnings per share

– Suppose 2 firms have same number of


outstanding share, same profits, but one has a
market value that is twice that of the other
– It offers a swap of 1 share for every 2 shares of
firm with lower market value
Boot Strapping

Firm A Firm B Firm AB


EPS 2 2 2.67
Price/Share 40 20 40
P/E Ratio 20 10 15
No. Of Shares 100,000 100,000 150,000
Total Earnings 200,000 200,000 400,000
Market value 4,000,000 2,000,000 6,000,000
Yield 0.05 0.1 0.067
Boot Strapping
• Total Earnings Double but the Number of
Shares Rises by 50 %

• No Real gain, but EPS has risen but PE


Ratio Declines

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