FIN 401 Lecture Notes - Lecture 10: Stock Swap, Cash Flow, Management
30 Apr 2018
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April 3th, 2018 Lecture 10 – FIN400
1
MERGERS AND ACQUISITIONS (CHAPTER 24)
Terminology in the Market for Corporate Control
• Acquirer
o A firm that buys another firm
o Also known as the bidder
• Target
o A firm that is acquired by another in a merger or acquisition
• Takeover
o Either a merger or an acquisition, by which ownership and control of a firm can
change
Merger Waves
• Merger Waves
o Peaks of heavy takeover activity followed by troughs of few transactions
o Merger activity is greater during economic expansions than contractions
o Also correlated with bull markets
Types of Mergers
• Horizontal merger
o Target and acquirer are in the same industry
• Vertical merger
o Target’s industry buys or sells to acquirer’s industry
• Conglomerate merger
o Target and bidder are in different industries
Forms of Payment in M&A
• Cash merger or acquisition
o Target shareholders receive cash as payment for target shares
• Stock swap
o Target shareholders receive stock as payment for target shares
• Payments can be very complex
o Usually some combination of forms of payment
Reasons to Acquire
• Synergies
o Value obtained from an acquisition that could not be obtained if the target
remained as an independent firm
o VAB > VA + VB
o ∆V = VAB – (VA + VB)
o Need to examine whether the synergies create enough benefit to justify the cost
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April 3th, 2018 Lecture 10 – FIN400
2
Example #1
Firms A and B are competitors with very similar assets and business risks.
Both are all-equity firms with after-tax cash flows of $300,000 per year forever, and both
have an overall cost of capital of 12%.
Firm A is thinking of buying Firm B.
The after-tax cash flow from the merged firm would be $660,000 per year.
Does the merger generate synergy? What is ΔV? What is the value of Firm B to Firm A?
Reasons to Acquire – Sources of Synergy
• Revenue enhancement
o Marketing gains
o Market power/monopoly gains
• Cost reductions
o Economies of scale and scope
o Economies of vertical integration
o Efficiency gains
• Replace inefficient management
• Tax gains
o Tax savings from operating losses
o Unused debt capacity
• Managerial Motives
o Conflicts of interest
o Overconfidence
• Diversification
o Diversification, in and of itself, is not a good reason for a merger
o Stockholders can normally diversify their own portfolio cheaper than a firm can
diversify by acquisition
Example #2
Consider two firms, C and D. Both firms will either make $150 million or lose $60
million every year with equal probability. However, the firms’ profits are perfectly
negatively correlated (any year C earns $150 million, D loses $60 million, and vice
versa).
Assume that the corporate tax rate is 40% and that it is not possible to carry back or carry
forward any losses.
a) What are the total expected after-tax profits of both firms when they are two separate
firms?
b) What are the expected after-tax profits if the two firms are combined into one firm
called CD but are run as two independent divisions?
Magical Earnings Growth
Mergers may create the appearance of growth in earnings per share even when the merger
itself creates no value
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find more resources at oneclass.com
April 3th, 2018 Lecture 10 – FIN400
3
If there are no synergies or other benefits to the merger, then the growth in EPS is just an
artifact of a larger firm and is not true growth
In this case, the P/E ratio should fall because the combined market value should not
change
Example #3
Consider two corporations that both have EPS of $8.
The first firm, ABC, is a mature company with few growth opportunities. It has 1 million
shares that are currently outstanding, priced at $49 per share.
The second firm, XYZ, is a young company with much more lucrative growth
opportunities. Consequently, it has a higher value: Although it has the same number of
shares outstanding, its stock price is $70 per share.
Assume XYZ acquires ABC using its own stock, and the takeover adds no value.
a) In a perfect market, what is the value of XYZ after the acquisition?
b) At current market prices, how many shares must XYZ offer to ABC’s
shareholders in exchange for their shares?
c) What is XYZ’s EPS after the acquisition?
d) Calculate XYZ’s price-earnings ratio, before and after the takeover.
Valuation of M&A
• Valuation methods
o Compare the target to similar companies
▪ Rough estimate
▪ Does not incorporate synergies
o Discounted cash flows
▪ Harder to implement, but does include synergies
Estimating the Value of Synergy
• Suppose that Firm A is planning to takeover Firm B.
• The value of Firm B to Firm A = VB* = VB + ∆V
• How can we determine VB*?
1. Estimate VB
▪ If Firm B is a public company, then VB can be observed directly
▪ If Firm B is private, then its value has to be estimated based on similar
companies that are public
2. Estimate ∆V (Synergy)
▪ Need to know the incremental CFs (∆CF)
▪ ∆ CF is the difference between the CF of the combined firm and the sum
of the CFs of the two firms considered separately
Making the Offer
• Public announcement
o Cash transaction
o Stock swap
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Merger waves: merger waves, peaks of heavy takeover activity followed by troughs of few transactions, merger activity is greater during economic expansions than contractions, also correlated with bull markets. Types of mergers: horizontal merger, target and acquirer are in the same industry, vertical merger, conglomerate merger, target"s industry buys or sells to acquirer"s industry, target and bidder are in different industries. Firms a and b are competitors with very similar assets and business risks. Both are all-equity firms with after-tax cash flows of ,000 per year forever, and both have an overall cost of capital of 12%. Firm a is thinking of buying firm b. The after-tax cash flow from the merged firm would be ,000 per year. Consider two firms, c and d. both firms will either make million or lose million every year with equal probability.
