analysis of securities

1. Chapter 21
Fundamentals of
Corporate
Finance
Fifth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Mergers, Acquisitions,
and Corporate Control

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Topics Covered
The Market for Corporate Control
Sensible Motives for Mergers
Dubious Reasons for Mergers
Evaluating Mergers
Merger Tactics
Leveraged Buy-Outs
The Benefits and Costs of Mergers

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The Merger Market
Proxy battle for control of the board of directors
Firm purchased by another firm
Leveraged buyout by a group of investors
Divestiture of all or part of the firm’s business
units
Methods to Change Management

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Recent Mergers
Acquiring Company Selling Company
Payment
($ billions)
JP Morgan Chase Bank One Corp 58.8
Proctor & Gamble Gillette Co. 57.0
Bank of America Corp. FleetBoston Financial Grp 49.3
Cingular Wireless AT&T Wireless 41.0
Sprint Corp. Nextel Communications 35.2
Johnson & Johnson Guidant Corp. 25.4
ChevronTexaco Unocal Corp. 16.4
AnthemInc. WellPoint Health Networks 16.4
SBC Corp. AT&T Corp. 16.0
Verizon MCI 8.5

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The Merger Market
Tools Used To Acquire Companies
Proxy Contest
Acquisition
Leveraged
Buy-Out
Management
Buy-Out
Merger
Tender Offer

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Sensible Reasons for Mergers
Economies of Scale
A larger firm may be able to reduce its per unit cost by
using excess capacity or spreading fixed costs across more
units.
$ $
$
Reduces costs

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Sensible Reasons for Mergers
Economies of Vertical Integration
Control over suppliers “may” reduce costs.
Over integration can cause the opposite effect.
Pre-integration
(less efficient)
Company
S
S
S
S
S
S
S
Post-integration
(more efficient)
Company
S

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Sensible Reasons for Mergers
Combining Complementary Resources
Merging may results in each firm filling in the
“missing pieces” of their firm with pieces from the
other firm.
Firm A
Firm B

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Sensible Reasons for Mergers
Mergers as a Use for Surplus Funds
If your firm is in a mature industry with few, if
any, positive NPV projects available, acquisition
may be the best use of your funds.

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Dubious Reasons for Mergers
Diversification
Investors should not pay a premium for
diversification since they can do it themselves.

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Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to low
number of shares)
After merger, acquiring firm has short term
EPS rise
Long term, acquirer will have slower than
normal EPS growth due to share dilution.

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Dubious Reasons for Mergers
The Bootstrap Game
World Enterprises
(before merger) Muck and Slurry
World Enterprises
(after buying Muck
and Slurry)
EPS $2.00 $2.00 $2.67
Price per share $40.00 $20.00 $40.00
P/E Ratio 20 10 15
Number of shares 100,000 100,000 150,000
Total earnings $200,000 $200,000 $400,000
Total market value $4,000,000 $2,000,000 $6,000,000
Current earnings
per dollar invested
in stock $0.05 $0.10 $0.067

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Evaluating Mergers
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)

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Evaluating Mergers
Economic Gain
Economic Gain = PV(increased earnings)
=
New cash flows from synergies
discount rate

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Evaluating Mergers
Example - Given a 20% cost of funds, what is the
economic gain, if any, of the merger listed below?
Cislunar Foods Targetco Combined Company
Revenues 150 20 172 (+2)
Operating Costs 118 16 132 (-2)
Earnings 32 4 40 (+4)
Economic Gain =
4
.20
= $20

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Evaluating Mergers
Estimated net gain
Estimated net gain = DCF valuation of target including synergies
- cash required for acquisition

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Merger Tactics
White 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.

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Leveraged Buy-Outs
Unique Features of LBOs
Large portion of buy-out
financed by debt
Shares of the LBO no longer
trade on the open market

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Leveraged Buy-Outs
Junk bond market
Leverage and taxes
Other stakeholders
Leverage and incentives
Free cash flow
Potential Sources of Value in LBOs