Mergers and Acquisitions – How businesses are valued

Definition of mergers and acquisitions

A merger refers to a combination of two firms which are almost equally strong. On combining, the two firms lose their original identity to form a completely new entity. In a takeover situation, the firm being acquired loses identity while the acquiring firm maintains its identity. The acquiring firm is usually called the predator while the firm being acquired is called a target. This article discusses diverse elements relating mergers and acquisitions.

mergers and acquisitions
what is the difference between ‘mergers’ and ‘acquisitions.’

Forms that mergers can take include:

1. Horizontal merger

This involves a merger between two firms in the same industry and at the same level of production forming a single entity in order to reduce competition against each other, for example, Price Waterhouse and Coopers & Lybrand merger to form PricewaterhouseCoopers.

2. Vertical merger

This is a merger between two firms at different levels of production such as a merger between a manufacturer and a supplier. An example would be a brewer merging with a bottle-making company.

3. Conglomerate merger

This is where the merging firms are in different industries. Such a merger is intended to diversify their areas of operations and minimize their risks.

Benefits of mergers and acquisitions

1. Diversification

This is achieved in the case of a conglomerate merger since the returns of the merging companies are negatively correlated, therefore it will result into reduction of the overall risk.

2. Asset backing

The predator may acquire the target in order to take over the assets that are underutilized and then utilize them to generate higher revenue.

3. Tax savings

This arises where the target has accumulated losses which if taken over will reduce the taxable income and the tax liability of the predator.

4. Management efficiency

This is where the predator acquires the target in order to take over its efficient management team.

5. Increased market share and market power

This arises in case of a horizontal merger since it involves the acquisition or merging of competitors.

6. Synergy

These are additional benefits associated with economies of a larger scale after merger and acquisition. It is the creation of a whole which is greater than the sum of its individual parts.

Examples of synergies include:

  1. Operational synergy: It results in economies of scale, scope and complementary resources.
  2. Management synergy – It results in efficiency gains from the combination of management teams.
  3. Financial synergy – It results in less volatile cash flows, lower default risk and a lower cost of teams.

Theoretical explanations to predict an acquisition/ take-over target in mergers and acquisitions

1. The growth-resource miss-match hypothesis

A company with high growth potential and low capital base will be an easy target. The predator can utilize the high growth potential to generate higher returns. Consequently a firm with low growth potential but high capital base means that the capital resource is underutilized. It therefore becomes an easy target where the resources are acquired by the predator and utilized to generate higher returns.

2. Industrial disturbance hypothesis

Firms in an industry following a lot of disturbances associated with regulations by the government, technological changes and high levels of competition become an easy target of acquisition or a merger in order to ensure survival.

3. Inefficient management team hypothesis

If the management of the firm is inefficient in utilization of the assets, it means the assets are underutilized and therefore renders the firm an easy target.

4. Size hypothesis

In almost all the cases, the predator will be a large company acquiring small target firm. This is because it is difficult for a small firm to acquire a large firm.

5. Price Earnings Ratio Hypothesis

To prevent dilution in the post-merger earnings per share, the predator will always acquire a target which has a lower price earning ratio ratio than itself. Therefore a firm with a low price earning ratio becomes an easy target of a takeover.

6. Market to Book-Value-per share Hypothesis

Firms whose market value to book value per share is low are considered as “cheap buys” therefore they become an easy target of a takeover.

Defensive mechanism or tactics against a hostile takeover in mergers and acquisitions

The following techniques can be used by a target in order to resist a hostile bid by a predator (usually a bigger company).

(1) Scorched earth policy

This is a combination of the sale of crown jewels in addition to which the target may take a suicidal act of borrowing high debt capital to increase its gearing and financial risk thereby reducing its attractiveness.

(2) Use of green mail

This is where the target makes a counter offer to acquire the shares of the predator. This is only possible if the two firms are almost equally strong. The counter offer will reduce the advances of the predator.

(3) Shark repellents

This involves making super majority amendments in articles of the firm such that the acquisition or take over must be supported by a super majority, that is, 80% of the members.

(4) Litigation and legal redress

This is where the target can apply to the regulatory authority to justify that the acquisition will make the predator a monopoly therefore breaking the anti-trust and anti-monopolist laws.

(5) The use of golden parachutes

Golden parachutes are the generous retirement packages to be granted to the management and employees of the target if the firm is taken over. This will significantly reduce the value of the target.

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Financing the acquisition or methods of purchase consideration during mergers and acquisitions

For the predator to acquire the target, the payment/ purchase consideration may take the following form:

(1) Share for share exchange

This is where the predator will be given a number of shares for every share of the target acquired. This is called the exchange ratio. In this method, the shareholders of the target become the shareholders of the predator.

Implications of share for share exchange

  1. It conserves the cash of the predator since there is no cash outflow.
  2. There is increase in the order share capital of the predator therefore reduction in gearing.
  3. The predator has to pay a premium to acquire the shares of the target.
  4. It dilutes the ownership and control of the predator since the shareholders of the target become the shareholders of the predator.

(2) Use of cash

This is where the shareholders of the target receive a cash payment and surrender their shares to the predator.

The implications of using cash to acquire a target are:

  1. A large cash outflow which may cause liquidity problems to the predator.
  2. The shareholders of the target receive a huge capital gain but completely lose their shareholding in both the predator and the target.

Use of convertible securities

In this case, the shareholders of the target surrender their shares and become either debenture holders or preference shareholders. They will continue receiving interest income or preference dividends from the predator.

The implications of using convertible securities are:

  1. Conservation of cash on the part of the predator.
  2. Increase in gearing on the predator due to issue of fixed returns securities.
  3. There is no dilution in ownership and control of the predator since new shares are issued.
  4. The shareholders of the target will lose their ownership in the predator and will only become debenture or preference shareholders.
  5. The predator will gain interest tax shield since interest charges are tax allowable.

(4) Combination of any of the three types of considerations above.

Value gaps and why they arise in mergers and acquisitions

These arise from the fact that market values of firms acquired typically fall short of the value that actual bidders would place on them.

Reasons why value gaps arise in mergers and acquisitions

 Poor financial management

The headquarters may be following poor financing or dividend policies.

Over enthusiastic bidding

Assessments of the bidding company management may not have been correct or shrouded by other reasons such as development.

Stock market inefficiency

The market may fail to assess the full value of a business because it is out of favor.

Stages of merger analysis during mergers and acquisitions

  • (1) Merger planning
  • (2) Searching and screening
  • (3) Financial evaluation

1. Merger planning

The predator should review its corporate objectives of acquisition in light of its strength and weaknesses. It should evaluate all of its businesses to identify those that need to be added and those to be dropped.

2. Searching and screening

This involves searching for a possible candidate for acquisition and short listing a few from any available depending on objectives to be attained.

3. Financial evaluation

This helps to determine the areas of risk, maximum amount payable for acquisition, and the best means of financing the merger.

Steps in financial evaluation in mergers and acquisitions

(1) Identify post-merger growth and profitability assumptions and scenarios.

(2) Project the cash flows magnitudes and their timings.

(3) Estimate the required rate of return desired.

(4) Compute the net present value for each scenario.

(5) Decide whether the acquisition is profitable on the basis of NPV criterion.

(6) Determine the best method that should be used to finance the merger. That is the method that produces the highest post-merger earnings per share.

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