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1 Sessions 11&12 Mergers & Acquisitions Damodaran: Chapter 24: 4,14,15 (read pages , empirical evidence on capital structure changes and dividend policy; pages , EVA) Damodaran Chapter 25: 10,14,16,22 Outline: I. Background. II. Theories of mergers. 1) Operating or financial synergies 2) Undervaluation of target 3) Manifestations of agency problems 4) Redistribution among stakeholders 5) Managerial inefficiencies & the value of corporate control III. Accounting, legal & tax considerations. 1) Pooling versus purchase accounting 2) Taxable versus tax-free reorganizations 3) Securities laws covering securities trading & takeover activity IV. Takeover defenses. M&A - 1

2 I. Background. Method of payment: 1. cash (tender offer) 2. stock Stock price effects to bidders and targets Valuation issues M&A - 2

3 II. Theories of Mergers. 1. Synergy (2+2=5) A. Operating synergies (revenue enhancing, or cost reducing) B. Financial Synergies. 2. Undervaluation theory (or information theory). Basis: The acquiring firm has information about the acquired firm which leads it to believe that the latter is undervalued. 3. Manifestation of agency problems. Empire building Risk reduction Hubris 4. Redistribution among stakeholders of the firm. Bondholder/stockholder 5. Managerial inefficiencies. When other mechanisms are not sufficient to control agency problems, the market for takeovers provides an external control of last resort. M&A - 3

4 III. Accounting, Tax & Legal Framework 1. Accounting issues. Two basic methods are used to account for business combinations - pooling-of-interests and purchase accounting. For any given business combination, these methods are not alternatives; only one will be appropriate to the circumstances. In the purchase method, the combination is viewed as one company acquiring another, and the required accounting closely parallels that used in the purchase of assets in the ordinary course of business. The purchase price of the acquired company is allocated to the net assets obtained; any difference between the cost of an acquired company and the sum of the fair values of tangible and identifiable intangible assets, less liabilities, is recorded as goodwill. Amortization of goodwill reduces earnings but may not be deductible for tax purposes. The incomes of the entities are combined only for periods after the acquisition date, with the income of the acquired company being adjusted to recognize depreciation and amortization on the revised net asset values. In the pooling-of-interests method, the transaction is viewed as a merger (pooling) of the ownership interests into a single entity as though that entity and its combined shareholder groups had always existed. The assets and liabilities of the constituent companies are carried forward at their previously recorded or historical amounts and the incomes of the enterprises, before and after the date of the transaction, are combined with no change. The basic rule is that transactions that don't qualify to use the poolingof-interests method must use the purchase method. One important to qualify for pooling is that the acquiring corporation can issue only common stock in exchange for substantially all (90%) of the voting common stock of the acquired company (stock mergers). 2. A simplified view of tax considerations. M&A - 4

5 The tax objectives of the buyer and seller often conflict. Reorganizations are generally classified as either "tax-free" or "taxable". In a tax-free transaction, a gain or loss is only recognized when the target's shareholders sell the financial assets they received in payment from the acquirer. Thus, if a business combination is formed and the acquirer pays the target in stock and if several conditions are fulfilled (see below) the target stockholders will not report any gain or loss at the time they receive the new stock. The acquirer does not revalue the acquired assets for income tax purposes. For a merger to qualify for tax-free treatment, a "continuity of interest" test is applied. Shareholders of the target, as a group, must retain a continuing equity interest in the acquirer, and the interest must be substantial in relation to the net assets of the target. These two rules are not precise and are most frequently interpreted to mean that shareholders of the target must receive at least 50% of the total value of the previously outstanding stock of the target in stock (common or preferred) of the acquirer. From the seller's viewpoint, the primary advantage to a tax-free acquisition is that any gain realized on the sale of the business is not recognized currently for tax purposes (he is taxed only when he sells his shares). The primary motive from the buyer's viewpoint is the desire to utilize tax attributes of the seller. Transactions which do not allow for continuity of interest are treated as taxable transactions. The acquiring firm can increase or step-up the tax basis of the acquired firm's assets to their fair market value and take depreciation charges on this new basis. A taxable reorganization also may be desirable from the seller's viewpoint if the seller requires liquidity or does not desire to hold the buyer's stock under any restrictions. M&A - 5

6 Examples of Tax & Accounting Considerations in Business Combinations. 1. An acquirer wants to buy a target that is currently involved in a major product liability suit. 2. In a hostile bidding war for a target, the acquirer is aiming to purchase most of the voting stock from risk-arbitrageurs. 3. An acquirer is considering purchasing a target. The asset base of the target has been largely depreciated. 4. An acquirer is considering purchasing a target for a price in excess of the fair market value of the net assets. Management of the acquirer is concerned about lowering reported earnings. M&A - 6

7 5. An acquirer has purchased for cash 21% of the voting stock of a target "in the market" during the last two months. It wants to effect full control as soon as possible. Management of the target, which controls 10% of the voting stock, is unfavorably disposed to the acquirer. 6. A company with substantial tax-loss carryforward is available. The company is not expected to earn sufficient profits to utilize its tax loss carryforward. In order to avoid losing the economic benefits of the tax loss carryforward (through delayed utilization or expiration in 15 years), a business combination with a highly profitable company might be quite attractive. M&A - 7

8 1. Legal framework a. Federal Securities Laws: The Securities Act of 1933 regulates the sale of securities to the public. The 1933 Act prevents the public offering and sale of securities without a registration statement The Securities Exchange Act of 1934 established the Securities and Exchange Commission (SEC) to administer the securities laws and to regulate practices in the purchase and sale of securities. The 1934 Act provides the basis for the amendments which are applicable to takeover activities. The Williams Act of 1968 was intended to protect target company shareholders takeovers by: generating more information during the takeover process which target shareholders and management could use to evaluate outstanding offers, and requiring a minimum period during which a tender offer must be held open. Important sections of the Williams Act include: 1. Section 13(d): any person that acquires more than 5% of the stock of a public corporation must file a Schedule 13D with the SEC within 10 days of crossing the threshold. 2. Section 16(b): the short swing profits rule. An insider (owner of > 10%) cannot make a profit on stock held less than 6 months. 3. Section 14: regulates the terms of tender offers. A schedule must be filed with the SEC "as soon as practicable" on the date of the commencement of the tender offer. b. State laws governing corporations. States are the primary regulators of corporate activities. Shareholders may be damaged by restrictive state legislation which limits takeovers. M&A - 8

9 IV. TAKEOVER DEFENSES Defensive measures can be classified as either: General "wall building", or Defensive actions in response to explicit threats. 1) Financial Defensive Measures. Adjustments in Asset and Ownership Structure Leveraged recap (leveraged cash-out). Outside shareholders receive a large one-time cash dividend and insiders (managers) receive new shares instead of the cash dividend. The cash dividend is financed mostly by newly borrowed funds. Golden Parachutes: separation provisions of an employment contract that compensate managers for the loss of their jobs under a change-ofcontrol clause. Poison Puts. Put option exercisable by bondholder (at 100 or 101%). Some bond issues have provided their holders with poison put covenants as a protection from the risk of takeover-related credit deterioration of the issuer. Targeted share repurchase (greenmail) and standstill agreements. The target firm repurchases through private negotiation a large block of its stock from an individual shareholder at a premium. 2) Antitakeover Amendments to Corporate Charter. The four most common amendments are : 1. Supermajority amendments: shareholder approval is required for all transactions involving change of control. 2. Fair price amendments: the supermajority requirement is waived if a fair price is paid for all purchased shares. 3. Classified boards (staggered): A new majority shareholder has to M&A - 9

10 wait to gain control of the board. 4. Authorization of preferred stock: board is authorized to create a new class of securities with special voting rights (typically preferred stock). 3) Poison Pill Defense: provides holders with special rights exercisable only after some time (for example, ten days) following the occurrence of a triggering event such as a tender offer for control or the accumulation of stock. 4) State anti-takeover laws M&A - 10

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