MergersChapter 32• Synergy: Value of the whole exceeds sum of the parts. Could arise from:– Economies of Scale– Operating economies– Financial economies– Differential management efficiency– Taxes (use accumulated losses)• Break-up value: Assets would be more valuable if broken up and sold to other companies.Sensible Reasons for MergersEconomies of Vertical Integration– Control over suppliers “may” reduce costs.– Over integration can cause the opposite effect. Pre-integration (less efficient)CompanySSSSSSSPost-integration (more efficient)CompanySSensible Reasons for MergersCombining Complementary ResourcesMerging may results in each firm filling in the “missing pieces” of their firm with pieces from the other firm.Firm AFirm BSensible Reasons for MergersMergers as a Use for Surplus FundsIf your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.Bank of America Family TreeNote: Ironically, MBNA was once owned by a previous version of Bank of America, which sold it in an IPO.• Diversification– Investors should not pay a premium for diversification since they can do it themselves• Purchase of assets at below replacement cost• Acquire other firms to increase size, thus making it more difficult to be acquiredDubious Reasons for MergersThe Bootstrap GameAcquiring Firm has high P/E ratioSelling firm has low P/E ratio (due to low number of shares) After merger, acquiring firm has short term EPS riseLong term, acquirer will have slower than normal EPS growth due to share dilution.• Friendly merger: – The merger is supported by the managements of both firms.• Hostile merger:– Target firm’s management resists the merger.– Acquirer must go directly to the target firm’s stockholders, try to get 51% to tender their shares.– Often, mergers that start out hostile end up as friendly, when offer price is raised.Estimating Merger Gains• Questions– Is there an overall economic gain to the merger?– Do the terms of the merger make the company and its shareholders better off?????PV(AB) > PV(A) + PV(B)Estimating Merger Gains)(paid Cash)(BABBABBAABPVcashPVlostgainNPVPVCostPVPVPVPVGainEstimating Merger Gains• Economic GainEconomic Gain = PV(increased earnings)= New cash flows from synergiesdiscount rateTakeover MethodsTools Used To Acquire CompaniesProxy ContestAcquisitionLeveraged Buy-OutManagement Buy-OutMergerTender OfferTakeover DefensesTakeover DefensesWhite Knight - Friendly potential acquirer sought by a target company threatened by an unwelcome suitor.Shark Repellent - Amendments to a company charter made to forestall takeover attempts.Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.Mergers (1962-2006)02,0004,0006,0008,00010,00012,000Number of Deals• According to empirical evidence, acquisitions do create value as a result of economies of scale, other synergies, and/or better management.• Shareholders of target firms reap most of the benefits, that is, the final price is close to full value.– Target management can always say no.– Competing bidders often push up prices.Do mergers really create