Lecture 12: Mergers and acquisitions (M&A)

Objectives: Understand the fundamental theory underpinning M&As Discuss the motives behind M&As Describe the methods of financing M&As Apply the various methods of share valuation under M&A Discuss the reasons for merger failure.
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Mergers and Acquisitions

Merger:
is where two companies come together to combine and share resources to achieve a common objectives.

Under merger the combining firms remain

joint owners new company is created
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Mergers and Acquisitions

Takeover or acquisition:
one firm purchase the assets of another, with the acquired firm ceasing to be the owners of that firm. Often it is the larger company which acquires a smaller one

Types of M & A
Horizontal merger :
two companies engaged in similar activities are combined

Vertical merger ;
firms from different points in the same production process decide to combine

Conglomerate merger:
occurs when two businesses in unrelated industries decide to combine
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Mergers and Acquisitions

Objectives of M&As Enhance shareholder wealth through competitive advantage Empire building

Mergers and Acquisitions

Theoretical perspective (pages 89-90 hand book)

Question
Is take over targets a way of disciplining managers who fail to seek the interest of shareholders (Market for Corporate Control) or are there motives different from this? From lecture 1 (agency problem). Read more on this area.

Motives of M & A
Economies of scale
to enable benefits of scale to be achieved

To reduce competition
to co-opt an existing competitor in order to reduce competition

Market power
increase market share
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Motives of M & A
Sharing complementary resources
bringing together the relative strength of each firm

New market entry

to facilitate expansion into new market

To reduce risk
diversification
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Motives of M & A
Managerial motive
to avoid being taken over (job security) to pursue growth in size, status and higher remuneration

Removal of inefficient Management -to remove managers who failed to maximise shareholder wealth
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Methods of Financing Mergers

Cash payment
pay the purchase consideration by cash

Shares
issue of ordinary and preference shares

Loan capital
debentures convertible loans
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Target Valuation
Methods: Asset-based methods
Balance sheet or net book values approach P = Total assets - total liabilities No of ordinary shares issued Net realisable values or replacement cost P = net realisable value - total liabilities No of ordinary shares issued
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Target Valuation
Stock market methods: For listed companies use the share price on the stock exchange

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Target Valuation
Cash flow methods: Gordons growth model Value of share= Dividend received Rate of return growth in dividend Free cash flow method: PV of future cash flow-total liabilities No of ordinary shares issued
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Target Valuation
Dividend Yield = Gross dividend per share Market value per share MV/S = Gross dividend per share Dividend yield P/E ratio = market value per share Earning per share
Market value per share = P/E ratio x EPS
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Lecture Example 12.1 CDC Ltd owns a chain of tyre and exhaust fitting garages in the London area. The company has been approached by ATD plc, with a view to a takeover of CDC Ltd. ATD plc is prepared to make an offer in cash or a share-for-share exchange. The most recent accounts of CDC Ltd are summarised below. Profit and loss account for the year ended 30 November, 20x1 m Turnover 18.7 Profit before interest and tax Interest Profit before taxation Corporation tax Net profit after taxation Dividend Retained profit 6.4 1.6 4.8 1.2 3.6 1.0 2.6
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Balance sheet as at 30 November, 20x1 Fixed Assets Freehold land and premises at cost Less: Accumulated Depreciation Plant and machinery at cost Less: Accumulated Depreciation

4.6 0.6 4.0 9.5 3.6 5.9 9.9

Current Assets Stock at cost Debtors Bank Less Creditor amount due within one year Trade creditors Dividends Corporation Tax 4.3 1.0 1.2

2.8 0.4 2.6 5.8

6.5 Total assets less current liabilities Less Creditor amount due beyond one year Loans (0.7) 9.2

3.6 5.6

Share capital and reserves Ordinary 1 shares Profit & loss

2.0 3.6 5.6

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The accountants for CDC Ltd has estimated the future free cash flow of the company to be as follows: 20x2 million 4.4 20x3 4.6 20x4 4.9 20x5 5.0 20x6 5.4

(Note: after 20x6 the figure is the same for the following 12 years). The company has a cost of capital of 10% CDC Ltd has recently had a professional valuer establish the current resale value of its assets. The current resale value of each asset was as follows: Freehold land and premises Plant and machinery Stock 18.2 4.2 3.4

The current resale values of the remaining assets are considered to be in line with their book values.
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A company which is listed on the Stock Exchange and which is in the same business as CDC Ltd has a gross dividend yield of 5 per cent and a price earning ratio of 11 times. Assume a standard rate of income tax of 25%. The financial director believes that replacement costs are 1 million higher than the resale values for both freehold land and premises, and the plant and machinery, and 0.5 million higher than the resale value of the stock. The replacement cost of the remaining assets is considered to be in line with their book values. In addition, the financial director believes the goodwill of the business has a replacement value of 10 million. Calculate: a) Net book value of an ordinary share in CDC Ltd. b) Value of ordinary share in CDC Ltd using the liquidation value method c) Value of ordinary share in CDC Ltd using the replacement method d) Value of ordinary share in CDC Ltd using the P/E ratio method e) The value of an ordinary share in CDC Ltd using the free cash flow method

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Target Valuation solution12.1

a) P = Total assets - total liabilities No of ordinary shares issued P = (9.9 + 5.8) (6.5 + 3.6) 2 = 2.8 b) Net realisable values or replacement cost P = net realisable value - total liabilities No of ordinary shares issued P = (18.2+4.2+3.4+0.4+2.6)-(6.5+3.6) 2 = 9.36
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Target Valuation
c) Replacement cost P = Assets at Replacement cost - total liabilities No of ordinary shares issued P = (19.2+5.2+3.9+0.4+2.6+10)-(6.5+3.6) 2 =15.6

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Target Valuation
d) P/E ratio = market value per share Earning per share Market value per share = P/E ratio x EPS 11 X 3.6 2
19.80

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Target Valuation
e) Cashflow DCF 10%
19x2 4.4 19x3 4.6 19x4 4.9 19x5 5.0 Next 13 yrs 5.4 0.91 0.83 0.75 0.68 4.90*

PV
4.0 3.82 3.68 3.40 26.46 41.36

41.36 -10.1 / 2.0 =15.63

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Failure of M & A
Reasons: Over-optimisation
Acquirers often pay too much for their targets as a result of flawed evaluation process that overestimates the likely benefits;

Failure of integration management

improper planning and execution of the integration process.
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Further Reading
Manne, Henry G. (1965) Mergers and the Market for Corporate Control The Journal of Political Economy, Vol 73, No 2 (April), pp. 110-120. Siriopoulos, C. et al (2006) Does the Market for Corporate Control hypothesis explain takeover targets? Applied Economics Letter, Vol. 13, pp. 557-561. Sudarsanam, P.S.(1995). The Essence of Mergers and Acquisitions, Prentice Hall.
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Thank you all for listening to me

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