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CHAPTER 22

Mergers and Corporate

Control

Verizon Communications made Verizon Wireless into a wholly owned subsidiary in 2014
with a $130 billion deal to acquire all the Verizon Wireless stock that it did not already
own. What does this have to do with Vodafone Group, a UK telecommunications
company? The story began in 1999 when Vodafone entered a joint venture with Bell
Atlantic, resulting in a mobile technology subsidiary called Verizon Wireless. At about
the same time, Bell Atlantic merged with GTE, the largest of the original Bell system
companies. The merged companies became Verizon Communications and owned 55%
of the Verizon Wireless subsidiary; Vodafone retained a 45% share in Verizon Wireless.
Vodafone soon made news in 2000 with its hostile takeover of Mannesmann AG, a
German technology giant, in a deal valued at $161 billion, the largest merger in history.
Through acquisitions and growth of its existing operations, Vodafone became one of
the two largest wireless phone companies in the world, second only to China Mobile.
Fast-forward to 2014. To obtain Vodafone’s 45% interest in Verizon Wireless, Verizon
Communications gave Vodafone over 1.2 million shares of Verizon Communications
stock (worth about $60.2 billion) and paid around $70 billion in cash (and other financial
assets). Vodafone then gave each of its own shareholders a proportional amount of the
Verizon Communications stock and paid its shareholders about $24 billion in a cash
distribution.
Think about these transactions as you read the chapter.

859

Copyright 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
860 Part 9 Strategic Finance in a Dynamic Environment

re source Most corporate growth occurs by internal expansion, which takes place when a firm’s
The textbook’s Web site existing divisions grow through normal capital budgeting activities. However, the most
contains an Excel file that dramatic examples of growth result from mergers, the first topic covered in this chapter.
will guide you through the
chapter’s calculations. Other actions that alter corporate control are divestitures—conditions change over time,
The file for this chapter is causing firms to sell off, or divest, major divisions to other firms that can better utilize
Ch22 Tool Kit.xlsx, and we the divested assets. A holding company is another form of corporate control in which one
encourage you to open the
file and follow along as corporation controls other companies by owning some, or all, of their stocks.
you read the chapter.
22-1 Rationale for Mergers
Many reasons have been proposed by financial managers and theorists to account for the
high level of U.S. merger activity. The primary motives behind corporate mergers are pre-
sented in this section.1

22-1a Synergy as a Motivation for Mergers

The primary motivation for most mergers is to increase the value of the combined enter-
prise. If Companies A and B merge to form Company C and if C’s value exceeds that of A
and B taken together, then synergy is said to exist, and such a merger should be beneficial
to both A’s and B’s stockholders. Synergistic effects can arise from five sources: (1) operating
economies, which result from economies of scale in management, marketing, production,
or distribution in which larger companies can reduce costs, increase sales, or both; (2) dif-
ferential efficiency, which implies that the management of one firm is more efficient and that
the weaker firm’s assets will be more productive after the merger; (3) financial economies,
including lower borrowing costs, lower transaction/issuing costs, and better coverage by
security analysts; (4) tax effects, in which case the combined enterprise pays less in taxes than
the separate firms would pay; and (5) increased market power due to reduced competition.
The first three sources (operating economies, differential efficiency, and financial
economies) are economically desirable because they increase productivity, leading to
lower prices for consumers and higher returns for investors.
The fourth source, tax effects, also benefits consumers and investors by reducing
firms’ costs. However, if the government collects less from businesses, then it is likely to
make up the loss by raising taxes for individuals, increasing the federal deficit, reducing
federal programs, or some combination of the three.
Increased market power (the fifth source of synergy) reduces competition, leading to
higher prices for consumers. For example, a monopoly is a market structure in which a
single firm has enough market power to deter new competitors from entering the market.
Without competition, the firm can maximize its profits by increasing prices until decreas-
ing sales offset its gains. If several firms dominate an industry and choose not to compete
on the basis of prices, then the market structure is an oligopoly. Because the firms jointly
behave much like a monopoly, they can charge higher prices to consumers. However, the
Antitrust Division of the Justice Department and the Federal Trade Commission are not
supposed to approve mergers that significantly reduce competition.2
For example, the proposed 2017 merger between health insurance giants Cigna and
Anthem was blocked because regulators feared that it would increase prices for consumers.
Rather than keep fighting in court, Anthem terminated the deal. Anthem also refused to

1
As we use the term, merger means any combination that forms one economic unit from two or more previous
ones. For legal purposes, there are distinctions among the various ways these combinations can occur, but our
focus is on the fundamental economic and financial aspects of mergers.
2
The Sherman Act (1890), the Clayton Act (1914), and the Celler Act (1950) make it illegal for firms to combine if
the combination tends to lessen competition. For interesting insights into antitrust regulations and mergers, see
B. Espen Eckbo, “Mergers and the Value of Antitrust Deterrence,” Journal of Finance, July 1992, pp. 1005–1029.

pay Cigna the $1.85 billion termination fee specified in their pre-merger agreement. Cigna
sued Anthem for refusing to pay the termination fee and asked the courts for another $13
billion in “damages.” Cigna needs this to offset its planned merger with Express Scripts
in which Cigna will increase its debt obligations by about $15 billion. As we write this in
October 2018, the Justice Department and most state regulators had approved the deal.
When mergers are completed, the expected synergies often fail to occur. For example,
Triarc Companies (which owned the Arby’s fast-food chain) acquired Wendy’s Interna-
tional in 2008, forming Wendy’s Arby’s Group. The former Arby’s shareholders retained
about $490 million worth of shares in the new company, a little more than they owned
prior to the merger. The former Wendy’s shareholders received new shares worth about
$2 billion. The merger didn’t create the hoped-for synergies—Arby’s performance prior
to the merger had a negative trend that continued after the merger. In 2011, the Wendy’s
Arby’s Group sold Arby’s for about $339 million, a significant decrease from its pre-
merger value.3

22-1b Tax Considerations as a Motivation for Mergers

Tax considerations often cause firms to merge. We describe different tax-related merger
motivations and deterrents in the following sections.

REDUCTION IN CORPORATE TAX RATES DUE TO THE

2017 TAX CUTS AND JOBS ACT (TCJA)
Recall from previous chapters that the TCJA reduced the federal corporate tax rate to
21%. All else equal, companies will have lower tax expenses, higher profits, and more free
cash flows (FCFs) under the TCJA. It is possible that these changes might induce potential
acquirers to seek out merger targets. However, the TCJA has the same impact on a poten-
tial target’s taxes, profits, and FCFs. With higher FCFs, the potential target’s market value
should increase, making its acquisition more expensive. Therefore, it is not clear whether
the reduction in the corporate tax rate will stimulate merger activity, all else held constant.

ACCUMULATED LOSSES AND INTEREST EXPENSES

A profitable company with a large amount of taxable income could acquire a firm with
low or negative income but with large accumulated tax losses. With a merger, the target’s
accumulated losses could immediately reduce taxes for the merged firms rather than be
carried forward and used in the future by the target.4
Recall that the TCJA limits the amount of interest expense a firm may deduct, with any
excess carried over to future years. Therefore, firms with carried-over interest expenses
might be good targets for highly profitable companies because the acquirer could imme-
diately deduct the carried-over interest.
However, the tax shield provided by a target’s carryovers of accumulated losses and
interest expenses will be smaller because the TCJA corporate tax rate is lower, which
reduces the value of the tax shield.
In addition, the TCJA might have a chilling effect on highly leveraged mergers in
which acquirers finance a large amount of the deal with debt. In these situations, the
acquirer itself might have more interest expenses than it can deduct for tax purposes.

3
The Wendy’s Arby’s Group reincorporated as the Wendy’s Company. Arby’s purchaser paid Wendy’s $130 mil-
lion in cash, transferred $19 million worth of stock in the new Arby’s to Wendy’s, and took on $190 million in
Arby’s debt, for a total of $339 million. In addition, Wendy’s gained about $80 billion in tax breaks resulting
from its loss on Arby’s.
4
Congress has made it increasingly difficult for firms to pass along tax savings after mergers by limiting the use
of loss carryforwards in a merger.

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862 Part 9 Strategic Finance in a Dynamic Environment

We believe that the TCJA will reduce the number of highly leveraged mergers, but
we are unsure about the Act’s overall effect on merger activity. Time will tell whether the
positive impact of a target’s carried-over interest expenses outweighs the negative impact
of reductions in highly levered acquisitions.

ACQUISITIONS VERSUS DISTRIBUTIONS TO SHAREHOLDERS

Another tax-related motive occurs when a firm has more free cash flow (FCF) than it
needs to support positive NPV internal investment opportunities. It could pay a special
dividend, but its stockholders would have to pay immediate taxes on the distribution. It
could repurchase stock, but the selling shareholders would have to pay capital gains taxes.
Instead, the firm could spare its stockholders from these negative tax consequences by
using the FCF to make an acquisition. Should a firm make a distribution to its sharehold-
ers or make an acquisition?
First, recall that high-wealth shareholders usually pay a 20% tax on dividends and
long-term capital gains. A 20% tax isn’t zero, but it’s significantly less than the rate on
ordinary income. In addition, most repurchases are for a relatively small percentage of a
company’s outstanding stock, so relatively few shareholders pay the capital gains tax. Note
also that the shareholders who do sell their stock might have other capital losses that offset
the gains. Thus, we are highly skeptical of the idea that companies make acquisitions to
spare their shareholder from taxes.
In contrast, we believe CEOs and boards of directors will make acquisitions for rea-
sons other than their fiduciary responsibility to act on behalf of shareholders. We discuss
empirical evidence related to shareholder value in Section 22-9.

22-1c Breakup Value as a Motivation for Mergers

Some takeover specialists estimate a company’s breakup value, which is the value of the
individual parts of the firm if they were sold off separately. Suppose the breakup value is
greater than the value of the firm, which often is true for conglomerates. A takeover spe-
cialist could acquire the firm at or even above its current market value, sell it off in pieces,
and earn a profit.

22-1d Diversification as a Motivation for Mergers

Managers often cite diversification as a reason for mergers. They contend that diversifica-
tion helps stabilize a firm’s earnings and thus benefits its owners. Stabilization of earnings
is certainly beneficial to employees, suppliers, and customers, but its value to stockhold-
ers is less obvious. For example, shareholders could diversify by purchasing stock in both
firms. Also, research shows that diversified conglomerates are worth significantly less
than the sum of their individual parts.5
The situation is different for the owner-manager of a closely held firm. To diversify, the
owner must sell some of the firm’s stock and use the proceeds to purchase other invest-
ments. However, it is difficult to sell closely held stock, and any profits from the stock sale
would be taxed as capital gains. Therefore, a merger might be the best way for an owner to
diversify personal wealth.

5
See, for example, Philip Berger and Eli Ofek, “Diversification’s Effect on Firm Value,” Journal of Financial
Economics, 1995, pp. 37–65; and Larry Lang and René Stulz, “Tobin’s Q, Corporate Diversification, and Firm
Performance,” Journal of Political Economy, December 1994, pp. 1248–1280.

22-1e Purchase of Assets below Their Replacement

Cost as a Motivation for Mergers
Sometimes a firm will be touted as an acquisition candidate because the cost of replacing
its assets is considerably higher than its market value. This is especially true in the natu-
ral resources industry; for example, an oil company’s reserves might be worth more on
paper than the company’s stock. Of course, converting paper value to monetary value isn’t
always as easy as it sounds.

22-1f Executives’ Personal Incentives

as a Motivation for Mergers
Many business decisions are based on executives’ personal motivations rather than on
sound economic analyses. Power, prestige, and higher compensation are associated with
running a larger corporation, which plays a prominent role in many mergers.6 Therefore,
some CEOs might advocate an acquisition for personal rather than business reasons.
Some executives and managers of acquired companies often lose their jobs or perks
and might oppose a merger for purely personal reasons. For example, on February 17, 2017,
Kraft Heinz announced that it was seeking to acquire Unilever, which would create a mas-
sive food and consumer goods giant. The offer price was over 17% higher than Unilever’s
current stock price. The offer must have pleased shareholders because Kraft Heinz’s stock
price increased by over 10% and Unilever’s by 15%. Two days later, Kraft Heinz withdrew
its offer due to Unilever’s intent to fight the merger. One of Kraft Heinz’s largest sharehold-
ers, 3G Capital Management, was well known to have a penchant for cost-cutting, includ-
ing eliminating perks like corporate jets. Perhaps this played a role in Unilever’s opposition.

S E L F -T E S T

Define synergy. Is synergy a valid rationale for mergers? Describe several situations that might
produce synergistic gains.
Suppose your firm could purchase another firm for only half of its replacement value. Would that
be a sufficient justification for the acquisition? Why or why not?
Discuss the pros and cons of diversification as a rationale for mergers.
What is breakup value?

22-2 Types of Mergers: Business Types, Acquisition

Methods, and Hidden Liabilities
We can classify mergers by business types or by purchase method and resulting legal lia-
bilities. We begin with the relationship between the acquirer’s businesses and the target’s
businesses.

22-2a Business Types

Economists classify mergers into four types based on the businesses of the acquirer and
target: (1) horizontal, (2) vertical, (3) congeneric, and (4) conglomerate.
In a horizontal merger, one firm combines with another in its same line of business; the
2017 merger of Sherwin-Williams with Valspar (painting industry) is an example. A roll-
up merger is a particular type of horizontal merger in which a firm purchases many small

6
See Randall Morck, Andrei Shleifer, and Robert W. Vishny, “Do Managerial Objectives Drive Bad Acquisi-
tions?” Journal of Finance, March 1990, pp. 31–48.

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864 Part 9 Strategic Finance in a Dynamic Environment

companies in the same industry and “rolls them up” to create a consolidated brand. This has
happened in many businesses, including garbage collection (e.g., Waste Connections), used
car sales (e.g., AutoNation), and even funeral homes (e.g. Services Corporation International).
In a vertical merger, one company’s products are used by the other company. The 2017
merger of Tecogen (a manufacturer of clean energy power generation systems for business
facilities) and American DG Energy (which owns and manages on-site power generation
systems) was a vertical merger.
Congeneric means “allied in nature or action”; hence, a congeneric merger involves
related enterprises but not producers of the same product (horizontal) and not firms in a
producer–supplier relationship (vertical). Verizon’s acquisition of Yahoo! is an example.
A conglomerate merger occurs when unrelated enterprises combine. Berkshire Hath-
away Inc. has completed numerous conglomerate mergers and acquisitions, resulting in
a variety of subsidiaries with different operations, including wholesale food, railroads,
specialty chemicals, and insurance.

22-2b Acquisition Method and Hidden Legal Liabilities

There are three primary purchase methods: (1) stock offerings to provide target share-
holders with stock in the acquirer’s post-merger company in exchange for their shares;
(2) cash offers to purchase assets; and (3) cash offers to purchase shares. The choice of
method affects the acquirer’s responsibility for hidden liabilities, which are liabilities that
are unknown by the acquirer at the time of the acquisition.
To avoid hidden liabilities, acquirers conduct a thorough investigation of the target.
Indeed, in a friendly merger, the acquiring firm would send a team with dozens of finan-
cial analysts, accountants, engineers, and so forth to the target firm’s headquarters. They
would go over its books, estimate required maintenance expenditures, set values on assets
such as real estate, petroleum reserves, and the like. This process is an essential part of any
merger analysis and is called due diligence.
In a cash purchase of assets, the acquirer and the target specify which assets and lia-
bilities go to the acquirer and which remain with the target. After the acquirer pays its
debtors, creditors, and the IRS, it usually pays a liquidating dividend to its shareholders
from the remaining cash. In general, the acquirer is not responsible for hidden liabilities
if it purchases the target’s assets. In contrast, the acquirer generally is responsible for hid-
den liabilities if the acquisition is an exchange of stock or a cash purchase of the target
shareholder’s stock.
There are two types of hidden liabilities. First, a target’s liability may be unforeseen
by both the acquirer and target. For example, future lawsuits might later arise from some-
thing in the target’s past. This most often occurs with product liabilities such as revela-
tions that one of the target’s pre-merger products is unsafe.
The second type of hidden liability is known by the target’s senior managers but is
hidden from the acquirer. This includes products that the target knows are unsafe and
fraudulent accounting by the target’s senior managers.
Sometimes a liability is known but is grossly underestimated at the time of the merger.
For example, Bayer AG acquired Monsanto Co. by means of a cash offer purchase of its
stock on June 7, 2018. Bayer knew prior to the acquisition that there was the possibility of
legal action against Monsanto due to accusations that its herbicide Roundup caused can-
cer but still proceeded with the merger.
As events later showed, Bayer misjudged its potential liability. A California resident
dying from cancer after exposure to Roundup was awarded $289 million on August 10,
2018 in a lawsuit against Bayer. After trading at €100 (about $118) at the time of the acqui-
sition, Bayer’s stock plummeted to €77 (about $87.50) when the verdict was announced.

S E L F -T E S T

What are the four types of business combinations through mergers?

What are three types of acquisition methods?
Is an acquirer responsible for the target’s hidden liabilities?

22-3 Level of Merger Activity

The number and value of mergers tend to rise and fall through the years in a cycle, known
as merger waves. There have been at least five merger waves: (1) Around 1900, horizontal
mergers (e.g., oil and steel industries) created monopolies. (2) In the 1920s, many mergers
consolidated industries (e.g., autos and utilities) and created oligopolies; others created
vertically integrated supply chains. (3) In the 1960s, firms in unrelated industries merged
into huge conglomerates. (4) The 1980s were characterized by hostile takeovers and con-
generic mergers. (5) In the 1990s, deregulation allowed mergers in once-sheltered indus-
tries (such as communications and financial services) and fostered cross-border mergers
creating enormous multinational corporations.
Subsequent waves, in our opinions, are driven primarily by economic conditions.
Figure 22-1 shows the value of worldwide mergers as a percentage of the world stock
FIGURE 22-1
Merger Activity

Value of World Wide

Mergers as a Percentage
of World Wide Stock
Market Capitalization
%
14 Mergers
Market Capitalization
Recession
12

0
1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

2017

Year
Note:
1. The shaded areas designate business recessions as defined by the National Bureau of Economic Research; see www.nber.org/cycles.
2. Data for merger activity are from the Institute for Mergers, Acquisitions and Alliances (IMAA): https://imaa-institute.org/mergers-and
-acquisitions-statistics/.
3. Data for worldwide stock market capitalization (in 2016 dollars) are from https://data.worldbank.org/indicator/CM.MKT.LCAP
.CD?view=chart.
4. The Consumer Price Index (CPI) is used to convert merger activity to 2016 dollars. See the U.S. Bureau of Economic Analysis and U.S.
Bureau of the Census, Trade Balance: Goods and Services, Balance of Payments Basis [BOPGSTB], retrieved from FRED, Federal
Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/BOPGSTB.

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866 Part 9 Strategic Finance in a Dynamic Environment

market capitalization. Not surprisingly, increased merger activity tends to occur in peri-
ods of high economic growth and technological innovation, while decreases are driven by
the same forces that lead to recessions.
Some mergers have been huge, such as the $161 billion merger of Vodafone AirTouch
and Mannesmann in 2000, still the biggest merger ever as we write this in 2018. Other
recent large mergers include Bayer’s $63 billion acquisition of Monsanto in 2018, Abbott’s
$25 billion acquisition of St. Jude Medical, Inc., in 2017, and Microsoft’s $26 billion acqui-
sition of LinkedIn in 2016.

S E L F -T E S T

What major “merger waves” have occurred in the United States?

22-4 Hostile versus Friendly Takeovers

For some mergers, the senior executives of two firms agree that merging would be mutu-
ally beneficial. In other situations, one firm’s executives fight tooth and nail to prevent the
merger. The following sections describe both of these situations.

22-4a Friendly Mergers

In the vast majority of merger situations, an acquiring company wishes to purchase a
target company and initiates negotiations with the target’s CEO. Sometimes the reverse
happens, and the target initiates merger conversations. The acquiring firm usually is
larger than the target, but there are plenty of examples in which a smaller firm acquires a
larger one.
Once an acquiring company has identified a possible target, it must (1) establish a suit-
able price, or range of prices, and (2) decide on the terms of payment—will it offer cash,
its own common stock, bonds, or some combination? Next, the acquiring firm’s managers
must decide how to approach the target company’s managers. If the acquiring firm has
reason to believe that the target’s management will approve the merger, then one CEO will
contact the other, propose a merger, and then try to work out suitable terms. If an agree-
ment is reached, then the two management groups will issue statements indicating that
they approve the merger.
The target’s management will recommend to its stockholders that they agree to the
merger. Generally, the stockholders are asked to tender (i.e., turn over) their shares to
a designated financial institution, along with a signed power of attorney that transfers
ownership of the shares to the acquiring firm. The target firm’s stockholders then receive
the specified payment, either common stock of the acquiring company (in which case
the target company’s stockholders become stockholders of the acquiring company), cash,
bonds, or some mix of cash and securities. This is the usual process in a friendly merger.
Microsoft’s acquisition of LinkedIn in 2016 is an example of a friendly merger.

22-4b Hostile Takeovers

Often, however, the target company’s management resists, and the takeover attempt is
called a hostile merger. If the acquiring company (often called a corporate raider) wishes
to persist, it will make a tender offer directly to the target’s shareholders, asking them
to tender their shares in exchange for the offered price. The target’s managers will urge
stockholders not to tender their shares, generally claiming that the offer is too low.
Target firms may also employ other takeover defenses, such as changing the bylaws
so that directors serve staggered terms, in which not all directors are elected at one time.

For example, only one-third of the seats are filled each year, and directors serve three-year
terms. As described in Chapter 13, staggered terms make it harder for a hostile raider to
purchase a minority stake in the company and then elect one of their allies to the board.
The target might also change the bylaws so that a merger must be approved by a super
majority (such as 75% of the votes) rather than by a simple majority. Another tactic is to
raise antitrust issues in the hope that the Justice Department will block the merger. Some-
times the target’s senior executives will ask another company (with a more friendly CEO
and board than the raider) to acquire them. If it agrees to try, the company is called a white
knight; if it is successful, the result is a defensive merger. For example, Valent Pharmaceu-
ticals International Inc. pursued a hostile takeover of Allergan Inc. (which manufactures
Botox). However, Allergan fought the takeover and in 2015 was acquired by Activis PLC in
a friendly merger. Alternatively, a target might seek out a white squire who is friendly to
current management and can buy enough of the target firm’s shares to block the merger.
As described in Chapter 13, the target might award the CEO a golden parachute,
which is a very large payment made to executives who are forced out when a merger takes
place. The target might adopt a poison pill defense, which is a shareholder rights provision
allowing existing shareholders in the target to purchase additional shares of stock at a
lower-than-market value if a potential acquirer purchases a controlling stake. Or it might
resort to greenmail and buy back stock from the raider at a price that is higher than the
market price. In return, the raider agrees to cease its acquisition attempt for a specified
number of years.
Most hostile takeover attempts fail, at least initially. For example, in early 2016, West-
lake Chemical Corp. made a $20 per share offer (part cash and part Westlake stock)
for Axiall, another large chemical company. Axiall opposed the acquisition attempt
even though the offer was almost double Axiall’s current stock price. Other companies
expressed an interest in acquiring Axiall, but Westlake offered $33 per share, all in cash,
and completed the acquisition later that year.

S E L F -T E S T

What is the difference between a hostile and a friendly merger?

Describe some takeover defenses.

22-5 Merger Regulation

The following sections describe important federal and state laws regulating mergers.

22-5a Federal Regulation: The Williams Act

As we explained in Section 22-1a, Congress passed antitrust laws to protect consumers
from higher prices resulting from mergers that reduced competition. These laws helped
consumers but did little to protect shareholders during hostile takeover attempts. Hostile
raiders often would make two-tier tender offers specifying that the acquirer would accept
shareholder tenders in the order they were received, with an implicit threat to lower the bid
price after 50% of the shares were in hand. The tender offers would expire within just a few
days; if not enough shares were tendered, the raider could call off the deal. To make matters
worse, the raider often failed to provide sufficient details for shareholders to determine the
value of any stock or other securities to be received in exchange for tendering their shares.
To address these problems, Congress passed the Williams Act in 1968, requiring the
following: (1) Acquirers must disclose their current holdings and future intentions within
10 days of amassing at least 5% of a company’s stock. (2) Acquirers must disclose the
source of the funds to be used in the acquisition. (3) The target firm’s shareholders must

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868 Part 9 Strategic Finance in a Dynamic Environment

be allowed at least 20 days to tender their shares; that is, the offer must be “open” for at
least 20 days. (4) If the acquiring firm increases the offer price during the 20-day open
period, then all shareholders who tendered prior to the new offer must receive the higher
price. These provisions reduced the acquiring firm’s ability to surprise management and
to stampede target shareholders into accepting an inadequate offer.

22-5b State Regulations

States have also passed laws designed to deter hostile takeovers. For example, a raider
often purchases enough of the target’s stock to have a big impact on any shareholder votes,
including those associated with the takeover. To limit this voting power, 27 states have
passed Control Share Acquisition statutes.7 For example, an Indiana law defined “control
shares” as 20% or more of voting shares. If the threshold is exceeded by a raider, then it
cannot vote unless approved by a majority (or supermajority) of shareholders who are not
(1) officers or inside directors of the target or (2) associates of the raider. The statute usu-
ally gives the owner of control shares the right to call for such a vote within a specified
number of days. A Control Share statute slows down the action and thus gives the target
firm time to mount a defense.
Over 30 states have Business Combination statutes that come into effect if a minority
shareholder, such as a raider, owns more than a specified percentage of voting shares. If
that is the case, the statute forbids the raider from acquiring the target for a period that is
often 3 to 5 years.
Over 30 states also have Expanded Constituency statutes that expressly permit the
board to consider stakeholders other than shareholders, such as employees. In fact, some
states have Assumption of Labor Contracts laws mandating that hostile acquirers continue
to honor existing labor contracts.
Some states have Fair Price Provisions that require a raider to pay the same price in a
two-tier tender offer instead of a high price in the first tier and a low price in the second.
In fact, some companies have Fair Price bylaws requiring that any merger bid must meet
or exceed a price that is determined from market conditions, such as the company’s or
industry’s price/equity ratio.
Several states have a Control Share Cash-Out statute. Suppose a company or investor
acquires enough stock in another company to exceed a threshold (such as 20% in Penn-
sylvania). Even if the purchaser doesn’t plan on immediately attempting an acquisition,
the target’s remaining shareholders can require the purchaser to buy their shares at a fair
price. This discourages investors from gaining a large minority interest unless they have
immediate plans to acquire the company.
Instead of deterring takeovers, some state laws are designed to protect target sharehold-
ers from their own managers. For example, some state laws put limits on the use of golden
parachutes, poison pills, and greenmail because these provisions enrich or entrench the
target’s senior executives at the expense of shareholders.
A Delaware court ruled that if multiple companies are bidding for a target, then the
target must accept the bid with the highest price. Revlon, Inc. was the target in the court
case, so the requirement is often called the “Revlon rule.” This ruling protects sharehold-
ers from their own entrenched executives by making it more difficult for a target to take
a lower offer from a white knight. About 10 states have adopted the Revlon rule. Interest-
ingly, about the same number of states have adopted rulings that specifically reject the
Revlon rule.

7
See Matthew D. Cain, Stephen B. McKeon, and Steven Davidoff Solomon, “Do Takeover Laws Matter?
Evidence from Five Decades of Hostile Takeovers,” Journal of Financial Economics, 2017, pp. 464–485.

S E L F -T E S T

Is there a need to regulate mergers? Explain.

Do the states play a role in merger regulation, or is it all done at the national level? Explain.

22-6 Overview of Merger Analysis

An acquiring firm must answer two questions. First, how much would the target be worth
after being incorporated into the acquirer? Notice that this may be quite different from
the target’s current value, which does not reflect any post-merger synergies or tax benefits.
Second, how much should the acquirer offer for the target? Following sections discuss set-
ting the offer’s price and structure (cash versus stock), but for now we focus on estimating
the post-merger value of the target.
There are two basic approaches used in merger valuation: discounted cash flow (DCF)
techniques and market multiple analysis.8 Survey evidence shows that virtually all invest-
ment banks use DCF techniques to estimate the current value of a target.9 As part of the
process, all respondents used constant growth models and market multiples to estimate
the horizon value. The market multiple approach assumes that a target is directly compa-
rable to the average firm in its industry. Because this procedure provides at best a ballpark
estimate, we will focus on discounted cash flow approaches.
There are three widely used DCF methods: (1) the free cash flow corporate valuation
method, (2) the compressed adjusted present value method, and (3) the free cash flow to
equity method, which is also called the equity residual method. As explained in Chapter
21, the compressed adjusted value is the only appropriate model if there is a nonconstant
capital structure during the explicit forecast period, something that often occurs in merg-
ers. Therefore, we will use only the compressed APV approach in the following section to
illustrate valuing a target and setting the bid price.

S E L F -T E S T

What are the two questions that an acquirer must answer?

What are four methods for estimating a target’s value?

22-7 Estimating a Target’s Value

Caldwell Inc., a large technology company, is evaluating the potential acquisition
of a smaller company, Tutwiler Controls. (Tutwiler is the same company examined in
Chapter 21.) If the acquisition takes place, it will occur on January 1, 2020, and so the
valuation will be as of that date and will be based on the capital structure and synergies
expected after the acquisition. Tutwiler’s stock is trading at $15.40. Tutwiler has 10 million
8
See Chapter 7 for an explanation of market multiple analysis.
9
See W. Todd Brotherson, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins, “Company Valua-
tion in Mergers and Acquisitions: How Is Discounted Cash Flow Applied by Leading Practitioners?” Journal
of Applied Finance, No. 2, 2014, pp. 43–51. For additional survey evidence, see Tarun K. Mukherjee, Halil
Kiymaz, and H. Kent Baker, “Merger Motives and Target Valuation: A Survey of Evidence from CFOs,” Journal
of Applied Finance, Fall/Winter 2004, pp. 7–23. For evidence on the effectiveness of market multiples and DCF
approaches, see S. N. Kaplan and R. S. Ruback, “The Market Pricing of Cash Flow Forecasts: Discounted Cash
Flow vs. the Method of ‘Comparables,’” Journal of Applied Corporate Finance, Winter 1996, pp. 45–60. Also
see Samuel C. Weaver, Robert S. Harris, Daniel W. Bielinski, and Kenneth F. MacKenzie, “Merger and Acquisi-
tion Valuation,” Financial Management, Summer 1991, pp. 85–96; and Nancy Mohan, M. Fall Ainina, Daniel
Kaufman, and Bernard J. Winger, “Acquisition/Divestiture Valuation Practices in Major U.S. Firms,” Financial
Practice and Education, Spring 1991, pp. 73–81.

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870 Part 9 Strategic Finance in a Dynamic Environment

outstanding shares, giving it a market cap of $154 million: 10($15.4) 5 $154. With $38 mil-
lion of outstanding debt, Tutwiler’s total market value is $192 million: $154 1 $38 5 $192.
Based on its debt and equity values, Tutwiler’s current capital structure consists of
almost 20% debt: $38/$192 5 19.79%. Caldwell intends to finance the acquisition with this
same proportion of debt and plans to maintain a target capital structure of 20% debt and
80% equity throughout the projection period and thereafter.10
Tutwiler is a publicly traded company, and its market-determined beta is 1.4. Given a
risk-free rate of 6% and a 5% market risk premium, the Capital Asset Pricing Model pro-
duces a required rate of return on equity, rsL , of:

rsL 5 rRF 1 b(RPM)

5 6% 1 1.4(5%) 5 13%

Tutwiler’s pre-tax cost of debt is 8%, and its federal-plus-state tax rate is 25%. Its
WACC is:

WACC 5 wdrd(1 2 T) 1 wsrsL

5 0.20(8%)(1 2 0.25) 1 0.80(13%)
5 11.6%

How much would Tutwiler be worth to Caldwell after the merger? The following sec-
tions answer this question.

22-7a Projecting Post-Merger Cash Flows

re source The first order of business is to estimate the post-merger cash flows that Tutwiler will
See Ch22 Tool Kit.xlsx produce. This is by far the most important task in any merger analysis. In a pure financial
for details.
merger, defined as one in which no operating synergies are expected, the incremental
post-merger cash flows are simply the target firm’s expected cash flows. In an operating
merger, in which the two firms’ operations are to be integrated, forecasting future cash
flows is obviously more difficult because potential synergies must be estimated. Managers
from marketing, production, human resources, and accounting play leading roles here,
with financial managers focusing on financing the acquisition and performing an analysis
designed to determine whether the projected cash flows are worth the cost.
In this chapter, we take the projections as given and concentrate on how they are ana-
lyzed. Using the same techniques explained in Web Extension 21A, we have created post-
merger projections for Tutwiler, taking into account all expected synergies and maintain-
ing a constant capital structure; see worksheet Explanation of Projections in the file Ch22
Tool Kit.xlsx.11 Both Caldwell and Tutwiler are in the 25% marginal federal-plus-state tax
bracket. The cost of debt after the acquisition will remain at 8%. The projections assume
that growth in the post-horizon period will be 5% due to synergies. Figure 22-2 shows
these projections (keep in mind that these projections differ from those of Chapter 21
because they reflect the synergies expected in the acquisition).
Panel A of Figure 22-2 shows selected items from the projected financial statements.
Panel B shows the calculations for free cash flow and the annual tax savings due to the
deductibility of interest.

10
Some mergers change the capital structure of the target. If Caldwell had chosen to do so, it would have used
the forecasting techniques for a changing capital structure, as explained in Chapter 21 and Web Extension 21A.
11
We rounded some of the projected values in the worksheet Explanation of Projections in Ch22 Tool Kit.xlsx
for the sake of clarity.

FIGURE 22-2
Post-Merger Projections for the Tutwiler Subsidiary (Millions of Dollars)

Source: See the file Ch22 Tool Kit.xlsx. Numbers are reported as rounded values for clarity but are calculated using Excel’s full precision. Thus,
intermediate calculations using the figure’s rounded values will be inexact.

Notes:
a
Interest expense is based on Tutwiler’s existing debt, new debt to be issued to finance the acquisition, and additional debt required to
finance annual growth.
b
Debt is existing debt plus additional debt required to maintain a constant capital structure. Caldwell will increase Tutwiler’s debt by
$7.475 million (from $38 million to $45.475 million) at the time of the acquisition in order to keep the capital structure constant. This
increase occurs because the post-merger synergies make Tutwiler more valuable to Caldwell than it was on a stand-alone basis. Therefore,
it can support more dollars of debt and still maintain the constant debt ratio.
c
The tax rate is 25%.

re source Analysts should conduct sensitivity, scenario, and simulation analyses on the esti-
See Ch22 Tool Kit.xlsx mated cash flows, as shown in Chapter 11.12 Indeed, risk analysis is an essential step in the
on the textbook’s Web
site for all calculations.
due diligence process.
Note that rounded Following is the valuation of Tutwiler.
intermediate values
are shown in the text,
but all calculations are
performed in Excel using
22-7b Valuation Using the Compressed
nonrounded values. APV Approach
The compressed APV approach requires an estimate of Tutwiler’s unlevered cost of equity.
As shown in Chapter 21, Tutwiler’s unlevered cost of equity is:

rsU 5 wsrsL 1 wdrd (22-1)

5 0.8(13%) 1 0.2(8%)
5 12.00%

12
In actual merger valuations, the cash flow calculations would be much more complex, normally including
such items as tax loss carryforwards, tax effects of plant and equipment valuation adjustments, and cash flows
from the sale of some of the subsidiary’s assets.

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872 Part 9 Strategic Finance in a Dynamic Environment

In other words, if Tutwiler had no debt, its cost of equity would be 12.00%.13
Alternatively, we can estimate the unlevered beta, bU, and then calculate the unlevered
cost of equity. We begin by estimating the beta for debt, bd, as shown in Chapter 21:

bd 5 (rd 2 rRF)yRPM (22-2)

5 (0.08 2 0.06)y0.05
5 0.4
As shown in Chapter 21, the unlevered beta is:

bU 5 [b 1 bd (wdyws)]y[1 1 (wdyws)] (22-3)

5 [1.4 1 0.4(0.2y0.8)]y[1 1 (0.2y0.8)]

5 1.2
Using the CAPM, the unlevered cost of equity is:

rsU 5 rRF 1 bU(RPM)

5 6% 1 1.2(5%) 5 12.00%
This is exactly the unlevered cost previously estimated. Because this alternative
approach requires that we assume the CAPM is the correct model and because it takes
extra steps, we usually use the first method shown in Equation 22-1.
The horizon value of Tutwiler’s unlevered cash flows (HV U,2024) and tax shield
(HVTS,2024) can be calculated using the constant growth formula with the unlevered cost
of equity as the discount rate, as shown in Chapter 21. The unlevered horizon value is
$294.075 million:14

FCF2025 FCF2024(1 1 gL)

HVU,2024 5 5 (22-4)
rsU 2 gL rsU 2 gL

$19.6050(1.05)
5 5 $294.075 million
0.12 2 0.05
The horizon value of the tax shield is $17.823 million:

TS2025 TS2024(1 1 gL)

HVTS,2024 5 5 (22-5)
rsU 2 gL rsU 2 gL

$1.18818(1.05)
5 5 $17.8227
0.12 2 0.05

13
Notice that we do not use the Hamada equation to lever or unlever beta to determine the required return on
equity because the Hamada equation assumes zero growth. Instead, we use Equation 22-1 to determine the
unlevered cost of equity, which assumes that the growing debt tax shield is discounted at the unlevered cost of
equity. See Chapter 21 for details of this process.
14
All calculations are performed in the Excel file Ch22 Tool Kit.xls, which uses the full nonrounded values.

Row 8 in Figure 22-2 shows the projected free cash flows. The unlevered value of oper-
ations is calculated as the present value of the free cash flows during the forecast period
and the horizon value of the free cash flows:

$11.9 $9.3 $12.3

VUnlevered 5 1 1
(1 1 0.12)1 (1 1 0.12)2 (1 1 0.12)3
$13.8 $19.605 1 $294.075
1 1
(1 1 0.12) 4
(1 1 0.12)5
5 $213.6 million
This shows that Tutwiler’s operations would be worth a little over $213 million if it had
no debt.
re source Row 9 shows the yearly interest tax savings. The value of the tax shield is calculated as
See Ch22 Tool Kit.xlsx the present value of the yearly tax savings and the horizon value of the tax shield:
on the textbook’s Web
site for all calculations. $0.9095 $0.9674 $1.0424
Note that rounded VTax shield 5 1 1
intermediate values (1 1 0.12) 1
(1 1 0.12) 2
(1 1 0.12)3
are shown in the text,
but all calculations are $1.1141 $1.1882 1 $17.8227
performed in Excel using 1 1
nonrounded values.
(1 1 0.12)4 (1 1 0.12)5
5 $13.8 million
Tutwiler’s total value of operations is the sum of its unlevered value and the value of
the tax shield:

VOps 5 VUnlevered 1 VTax shield

5 $213.6 1$13.8 5 $227.4 million

The value of the equity is equal to this total value less Tutwiler’s outstanding debt:

VEquity 5 VOps − Debt

5 $227.4 − $38 5 $189.4 million

As this analysis shows, Caldwell estimates that Tutwiler’s equity would be worth about
$189 million. How much should Caldwell offer to Tutwiler’s shareholder? The answer is
in the next section.

S E L F -T E S T

Why is the adjusted present value approach appropriate for situations with a changing capital
structure?
Describe the steps required to apply the APV approach.

22-8 Setting the Bid Price

Under the acquisition plan, Caldwell would assume Tutwiler’s debt and would also take
on additional short-term debt as necessary to complete the purchase. The valuation model
shows that $189.4 million is the most it should pay for Tutwiler’s stock. If it paid more, then
Caldwell’s own value would be diluted. On the other hand, if it could get Tutwiler for less
than $189.4 million, Caldwell’s stockholders would gain value. Therefore, Caldwell should
bid something less than $189.4 million when it makes an offer for Tutwiler.

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874 Part 9 Strategic Finance in a Dynamic Environment

Now consider the target company. As stated earlier, Tutwiler’s market value of equity
as an independent operating company is $154 million. If Tutwiler were acquired at a price
greater than $154 million, then its stockholders would gain value, whereas they would lose
value at any lower price.
The difference between $189.4 million and $154 million, which is about $35.4 million,
is due to synergistic benefits expected from the merger. If there were no synergistic ben-
efits, the maximum bid would be the current value of the target company. The greater the
synergistic gains, the greater the gap between the target’s current price and the maximum
the acquiring company could pay.
The issue of how to divide the synergistic benefits is critically important. Obviously,
both parties would want to get the best deal possible. In our example, if Tutwiler knew the
maximum price Caldwell could pay, Tutwiler’s management would argue for a price close
to $189.4 million. Caldwell, on the other hand, would try to get Tutwiler at a price as close
to $154 million as possible.
Where, within the range of $189.4 to $154 million, will the actual price be set? The
answer depends on a number of factors, including whether Caldwell offers to pay with
cash or securities, the negotiating skills of the two management teams, and, most impor-
tantly, the bargaining positions of the two parties as determined by fundamental eco-
nomic conditions. Let’s first consider bargaining power and then examine the mechanics
of a cash offer versus a stock offer.

22-8a Relative Bargaining Power

To illustrate the relative bargaining power of the target and the acquirer, assume there
are many companies similar to Tutwiler that Caldwell could acquire, but suppose that no
company other than Caldwell could gain synergies by acquiring Tutwiler. In this case,
Caldwell would probably make a relatively low, take-it-or-leave-it offer, and Tutwiler
would probably take it because some gain is better than none.
On the other hand, if Tutwiler has some unique technology or other asset that
many companies want, then once Caldwell announces its offer, others would probably
make competing bids, and the final price would probably be close to $189.4 million.
If some other company has a better synergistic fit or a more optimistic management
team, then the offer price might be higher than the maximum of $189.4 million that
Tutwiler might pay.
Caldwell would, of course, want to keep its maximum bid secret, and it would plan its
bidding strategy carefully. If Caldwell thought other bidders would emerge or that Tutwil-
er’s management might resist in order to preserve their jobs, Caldwell might make a high
preemptive bid in hopes of scaring off competing bids or management resistance. On the
other hand, it might make a lowball bid in hopes of “stealing” the company.15

22-8b Cash Offers versus Stock Offers

Most target stockholders prefer to sell their shares for cash rather than to exchange them
for stock in the post-merger company. Following is a brief description of each payment
method.

15
For an interesting discussion of the after-effects of losing a bidding contest, see Mark L. Mitchell and
Kenneth Lehn, “Do Bad Bidders Become Good Targets?” Journal of Applied Corporate Finance, Summer 1990,
pp. 60–69.

CASH OFFERS
Tutwiler’s pre-merger equity is worth $154 million. With 10 million shares outstanding,
Tutwiler’s stock price is $154/10 5 $15.40. If the synergies are realized, then Tutwiler’s
equity will be worth $189.4 million to Caldwell, so $189.4/10 5 $18.94 is the maximum
price per share that Caldwell should be willing to pay to Tutwiler’s stockholders. For
example, Caldwell might offer something between $15.40 and $18.94, such as $16.40 cash
for each share of Tutwiler stock.

STOCK OFFERS
In a stock offer, Tutwiler’s stockholders exchange their Tutwiler shares for new shares in the
post-merger company, which will retain the name Caldwell. Targets typically prefer cash
offers to stock offers, all else equal, but taxation of the offer prevents all else from being equal.
We discuss taxation in more detail in Section 22-10, but for now you should know that stock
offerings are taxed more favorably than cash offerings. In this case, perhaps Caldwell should
offer stock in the post-merger company that would be worth $16.80 per share. With 10 million
outstanding Tutwiler shares, the Tutwiler shareholders must end up owning $16.80 3
10 million 5 $168 million worth of stock in the post-merger company. How many shares in
the post-merger Caldwell-Tutwiler company must the Tutwiler shareholders be offered?
Suppose Caldwell has 40 million shares of stock outstanding (nOld) prior to the merger
and the stock price is $40.53 per share. Then the total pre-merger value of Caldwell’s
equity is $40.53 3 20 million 5 $810.6 million. As calculated previously, the post-merger
value of Tutwiler to Caldwell is $189.4 million. Therefore, the total post-merger value of
Caldwell-Tutwiler’s equity will be $189.4 million 1 $810.6 5 $1,000 million.
After the merger, Tutwiler’s former stockholders should own $168/$1,000 5 0.168 5
16.8% of the post-merger company. With 20 million Caldwell shares outstanding, Caldwell
must issue enough new shares, nNew, to the Tutwiler stockholders (in exchange for the
Tutwiler shares) so that Tutwiler’s former stockholders will own 16.8% of the post-merger
stock:

Percent required by nNew

5
target stockholders nNew 1 nOld
nNew
16.8% 5
nNew 1 20
20 3 0.168
nNew 5 5 4.04 million
1 2 0.168
Tutwiler’s former stockholders will exchange 10 million shares of stock in Tutwiler for
4.04 million new shares of stock in the post-merger company. Thus, the exchange ratio is
4.04/10 5 0.404.
After the merger, there will be 4.04 million new shares, for a total of 24.04 million
shares. With a combined intrinsic equity value of $1,000 million, the resulting price per
share will be $1,000/24.04 5 $41.60. The total value owned by Tutwiler’s shareholders is
this price multiplied by their shares: $41.60 3 4.04 million 5 $168 million. Notice that
this is exactly the value that Caldwell offered at the beginning of this analysis. Also notice
that Caldwell’s stock price will increase from $40.53 per share before the merger to $41.60
after the merger. In this example, it is a win–win outcome for all shareholders, assuming
that the expected post-merger synergies are realized.

S E L F -T E S T

Explain the issues involved in setting the bid price.

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876 Part 9 Strategic Finance in a Dynamic Environment

22-9 Who Wins: The Empirical Evidence

Do mergers create value? Who wins in a merger, the acquirer or the target? What impact
do federal or state regulations have on mergers? How effective are changes in bylaws in
protecting entrenched executives? The following sections address these questions.

22-9a Value Created by Mergers

Are the decisions executives make about mergers in their shareholders’ interests or in
their own interests? To answer that question, researchers assume that investors’ beliefs
should affect stock price reactions when plans for a merger are announced. Researchers
also know that market conditions will affect the stock prices of most companies, includ-
ing bidders and targets. For example, if a merger was announced on a day when the entire
market rose, then a rise in the target firm’s price would not necessarily mean that the
merger was expected to create value. Therefore, researchers must disentangle the portion
of return due to the announced merger and the portion due to general market conditions.
To do this, researchers first determine the expected return for the bidder and target on the
announcement day using the CAPM, the Fama-French three-factor model, or even mod-
els with additional factors.16 They subtract this expected return from the actual return
to identify the abnormal return associated with the merger announcement. Using a large
sample of mergers, researchers calculate the abnormal returns for the bidding company
and the target.
Such event studies have examined nearly every acquisition involving publicly traded
firms from the early 1960s to the present. The results are remarkably consistent: The aver-
age abnormal stock return for target firms is about 30% in hostile tender offers and 20%
in friendly mergers. However, the average abnormal return is close to zero for acquiring
firms whether the merger is friendly or hostile. Keep in mind that these results are for the
average impact of mergers; some mergers create substantial value, and some destroy value.
However, research strongly indicates that the average acquisition creates value but that the
target firms’ shareholders reap almost all of the benefits.

22-9b The Impact of Takeover Regulations and Bylaw

Changes on Hostile Mergers
Cain, McKeon, and Solomon examined takeover regulations and hostile takeovers.17 Fol-
lowing is a summary of their key findings.
Recall that the 1968 Williams Act required bidders to provide targets with more infor-
mation and more time to respond. Before the Act, about 40% of mergers were hostile.
By 2013, fewer than 9% of mergers were hostile, indicating major changes in the merger
environment. The following sections identify which regulation and bylaw revisions con-
tributed to the current merger environment.
Fair Price laws deter hostile takeover offers. This is as might be expected because Fair
Price laws increase a raider’s cost in a two-tiered offer. Assumption of Labor Contracts
statutes also reduce hostile bids. This makes sense because raiders cannot reduce wages
and benefits due under the target’s current contracts. The Revlon rule encourages hostile
takeovers, probably because it requires a target’s board to accept the best price among
multiple offers.

16
See Chapter 6 for descriptions of the CAPM and the Fama-French three-factor model.
17
See Cain, McKeon, and Solomon, op. cit., footnote 7.

Recall that under the Control Share Cash-Out statute, shareholders can require an inves-
tor with a large minority interest to purchase their shares at a fair price. This serves to dis-
courage large minority ownership and instead stimulates hostile mergers. This may be due
to the presence of dissatisfied target shareholders who sell additional shares to the minority
owner because they want the change in leadership that often follows a hostile takeover.
Somewhat surprisingly, although restrictions on golden parachutes, poison pills, or
greenmail make hostile takeovers less costly, none have a significant effect on takeovers.
Neither do the other regulations and defenses described in Sections 22-4 and 22-5.
Cain, McKeon, and Solomon use results like those just described to create a Takeover
Index measuring a company’s susceptibility to a hostile takeover bid. They show that the
value of a firm’s stock is lower if the firm is less susceptible to a takeover, all else held
equal. In other words, if executives are not worried about a hostile takeover, then their
shareholders suffer. The researchers also show that if a firm is not very susceptible to a
merger, then its executives have a strong bargaining position when a merger offer comes.
As a result, a bid from an acquirer is at higher price than a bid for firms with higher sus-
ceptibility. Obviously, this discourages takeovers and adds insult to injury: Not only is a
shareholder’s stock less valuable, but also it will remain so until a generous bidder makes
a high offer. This means that an acquirer must make a high offer to displace the target’s
entrenched executives.

S E L F -T E S T

Explain how researchers can study the effects of mergers on shareholder wealth.
Do mergers create value? If so, who profits from this value?
Do the research results discussed in this section seem logical? Explain.

22-10 The Role of Investment Bankers

Investment bankers are involved with mergers in five ways: (1) They help arrange merg-
ers. (2) They help target companies develop and implement defensive tactics. (3) They help
value target companies. (4) They help finance mergers. (5) They invest in the stocks of
potential merger candidates.

22-10a Arranging Mergers

The major investment banking firms have merger and acquisition specialists who try to
arrange mergers. They identify firms with excess cash that might want to buy other firms,
companies that might be willing to be bought, and firms that might, for a number of rea-
sons, be attractive to others. Sometimes dissident stockholders of firms with poor track
records work with investment bankers to oust management by helping to arrange a merger.

22-10b Developing Defensive Tactics

Target firms that do not want to be acquired generally enlist the help of an investment
banking firm along with a law firm that specializes in mergers. The investment bankers
and lawyers help the target implement the takeover defenses described in Section 22-4b.

22-10c Establishing a Fair Value

If an acquirer pays a relatively low price for a target, then the target’s shareholders might
sue their executives and board for not acting in the shareholders’ interests. The reverse
is true if the price is high; the bidder’s shareholders might sue their own executives and

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878 Part 9 Strategic Finance in a Dynamic Environment

board. Therefore, the acquirer and target each usually hire an investment bank to estimate
the target’s fair value.
Because an investment bank’s managers receive more compensation for a completed
deal than for a failed takeover attempt, they have an incentive to estimate a “fair value”
that is high enough to ensure that the target accepts the offer. However, research shows
that overpricing hurts the investment bank in two ways. First, if an investment bank rep-
resented past acquirers that consistently had poor abnormal announcement returns (an
indication of overpricing the offer), then that investment bank is much less likely to be
retained as an advisor in subsequent deals or to be hired as an advisor by other acquirers
in future deals. Second, if the investment bank is itself a publicly traded company and its
client (i.e., an acquirer) has a positive abnormal announcement return, then the invest-
ment bank’s own stock tends to have a positive return. The opposite is true if the client has
a negative abnormal announcement return. Therefore, investment banks have an incen-
tive to recommend an offer price that reflects the target’s fair value.18

22-10d Financing Mergers

To be successful in the mergers and acquisitions (M&A) business, an investment banker
must be able to offer a financing package to clients—whether they are acquirers who need
capital to take over companies or target companies trying to finance stock repurchase
plans or other defenses against takeovers. In fact, the fees that investment banks generate
through issuing merger-related debt often dwarf their other merger-related fees.

22-10e Arbitrage Operations

Major brokerage houses, as well as some wealthy private investors, often purchase shares
of likely takeover targets. They hope that a takeover soon will be announced, driving
up the target’s stock price. This is called risk arbitrage, even though true arbitrage is
not risky.

S E L F -T E S T

What are some defensive tactics that firms can use to resist hostile takeovers?
What is the difference between pure arbitrage and risk arbitrage?

22-11 Other Business Combinations

The following sections describe mergers of equals, holding companies, and corporate
alliances.

22-11a Merger of Equals

In a typical merger, a large firm acquires a smaller firm. However, in some situations it
is hard to identify an “acquirer” and a “target” because shareholders and executives from
both pre-merger companies have approximately the same amount of control in the post-
merger company. Therefore, it is a “merger of equals” that consolidates the two companies.
For example, Office Depot, Inc. and OfficeMax Incorporated merged in 2013. After
the merger, shareholders from OfficeMax held about 45% of the post-merger stock. The
new board had an equal number of independent directors from each pre-merger company.

18
See John J. McConnell and Valeriy Sibilkov, “Do Investment Banks Have Incentives to Help Clients Make
Value-Creating Deals?” Journal of Applied Corporate Finance, 2016, No. 2, pp. 103–117.

Both of the pre-merger CEOs served as co-CEOs until later in the year when a new CEO
was hired from outside both companies. This was a bit unusual because the CEO from one
company often becomes the CEO of the merged company while the other CEO becomes
the president.

22-11b Holding Companies

Holding companies are corporations formed for the sole purpose of owning the stocks of
other companies. In this situation, the holding company is called a parent company, and
the other companies are called subsidiaries or operating companies.
A holding company provides two principal advantages relative to a company that sim-
ply has different divisions. First, a holding company can control other companies through
fractional ownership. For example, a holding company might buy enough shares of stock
in another company to give it effective working control of the other company’s operations.
Working control might be possible even if the holding company owns less than 25% of the
subsidiary’s common stock. As they say on Wall Street, “If management thinks you can
control the company, then you do.”
A second advantage is the isolation of risks. Because the operating companies are sepa-
rate legal entities, the obligations of one subsidiary are separate from those of the others.
Therefore, other operating companies may be protected from claims arising if another
incurs catastrophic losses or gigantic legal claims. This separation of risk sometimes can
be pierced, particularly if lenders require the holding company to guarantee its subsidiar-
ies’ debt.
The main disadvantage incurred by a holding company is partial multiple taxa-
tion of dividends in which the holding company’s shareholders are taxed on dividends
received from the holding company, which itself might be taxed on dividends received
from the operating companies. If the holding company owns less than 20% of the oper-
ating company, the holding company may deduct only 70% of the dividends it receives
and is taxed on the remainder. If it owns more than 20% but less than 80%, it can deduct
80% of the dividends received. If it owns at least 80% of a subsidiary’s voting stock, the
IRS permits the filing of consolidated returns, in which case dividends received by the
parent are not taxed
Holding companies can have high financial leverage that is not easily recognized by its
shareholders. For example, suppose a holding company, Company A, raises $100 million
in debt and $100 million in equity, giving it a total of $200 million in cash and a debt ratio
of 50%. Suppose a second holding company, Company B, raises $200 million in equity
from A and another $200 million in debt. Company B now has a total of $400 million in
cash and a 50% debt ratio. Company A owns all of the equity in Company B.
Now suppose an operating company, Company C, raises $400 million in equity from
Company B and raises another $400 million in debt, providing it with $800 million in
cash and a 50% debt ratio. Company B owns all of the equity in C, and C invests the entire
$800 million in operating assets.
Company A owns B and B owns C, so Company A owns all the stock in the chain and
has complete control of the operating company, Company C. Even though each link in
the chain has a 50% debt ratio, the entire chain’s debt ratio is 87.5% ($700/$800 5 0.875 5
87.5%). Not only is the true debt ratio of 87.5% not very transparent, but even small losses
by the operating company can trigger bankruptcy for the entire chain.
Because many utility companies went bankrupt due to levered chains, Congress
passed the Public Utility Holding Company Act in 1935 to restrict such chains and reduce
the risk of bankruptcy for utilities. In 2005, Congress repealed this Act, allowing pyramid
structures in public utilities.

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880 Part 9 Strategic Finance in a Dynamic Environment

22-11c Corporate Alliances

Some companies strike cooperative deals, called corporate alliances or strategic alliances,
which stop far short of merging. Whereas mergers combine all of the assets of the firms
involved, as well as their ownership and managerial expertise, alliances allow firms to
create combinations that focus on specific business lines that offer the most potential syn-
ergies. These alliances take many forms, from simple marketing agreements to joint own-
ership of worldwide operations.
One form of corporate alliance is the joint venture, in which parts of companies are
joined to achieve specific, limited objectives. A joint venture is controlled by a manage-
ment team consisting of representatives of the two (or more) parent companies. A study
of corporate alliances found that about 43% of alliances were marketing agreements, 14%
were R&D agreements, 11% were for licensing technology, 7% for technology transfers,
and 25% for some combination of these four reasons.19 The typical alliance lasted at least
5 years. When an alliance was announced, the average abnormal return for each part-
ner was 0.64%. The market reacted most favorably when the alliance was for technology
sharing between two firms in the same industry. In addition, the allied firms had better
operating performance than their industry peers during the first 5 years of the alliance.

S E L F -T E S T

What is a merger of equals?

What is a holding company?
What are some of the advantages of holding companies? Identify a disadvantage.
What is the difference between a merger and a corporate alliance?
What is a joint venture? Give some reasons why joint ventures may be advantageous to the parties
involved.

22-12 Divestitures
There are four types of divestiture.The first is a sale of assets to another firm. This gen-
erally involves the sale of an entire division or unit, usually for cash but sometimes for
stock in the acquiring firm. The second type is a liquidation, where the assets of a division
are sold off piecemeal to many purchasers rather than as a single operating entity to one
purchaser.
In a spin-off, a firm’s existing stockholders are given new stock representing separate
ownership rights in the division that was divested. The division establishes its own board
of directors and officers, and it becomes a separate company. The stockholders end up
owning shares of two firms instead of one, but no cash has been transferred. For example,
Biogen had a relatively stable business line focused on hemophilia and a more risky one
directed toward neurological diseases. In 2017, Biogen spun off its hemophilia business
into a newly created company, Bioverativ. Shareholders of Biogen kept their shares but
also received two shares of Bioverativ. This spin-off increased investor transparency and
managerial focus by separating the two different lines of business.
In an equity carve-out, a minority interest in a corporate subsidiary is sold to new
shareholders, so the parent gains new equity financing yet retains control. For exam-
ple, in 2016, Ashland Global Holdings, Inc. carved out its lubricant and oil change busi-
ness (Valvoline, Inc.) with an initial public offering. Valvoline raised $759 million in the

19
See Su Han Chan, John W. Kensinger, Arthur J. Keown, and John D. Martin, “When Do Strategic Alliances
Create Shareholder Value?” Journal of Applied Corporate Finance, Winter 1999, pp. 82–87.

IPO and also raised $750 million in a separate debt offering. As part of the transaction,
Valvoline transferred about $1.4 billion to Ashland, which retained an 83% ownership of
Valvoline stock. Like most equity carve-outs, the parent (Ashland) received cash and still
maintained a significant ownership in the newly separated company. The story doesn’t
end there: In 2017, Ashland distributed its Valvoline shares to Ashland shareholders, com-
pletely severing Ashland’s ties to Valvoline.
In general, the empirical evidence shows that the market reacts favorably to divesti-
tures, with the divesting company typically having a small increase in stock price on the
day of the announcement. The announcement-day returns are largest for companies that
“undo” previous conglomerate mergers by divesting businesses in unrelated areas.20 Stud-
ies also show that divestitures generally lead to superior operating performance for both
the parent and the divested company.21

S E L F -T E S T

What are some types of divestitures?

What are some motives for divestitures?

22-13 Merger Tax Treatments

Recall from Section 22-2 that there are three major acquisition methods. We show here
that each is treated differently for tax purposes. First, if it is a stock offering to provide tar-
get shareholders with stock in the acquirer’s post-merger company in exchange for their
shares, then it is a nontaxable exchange.22 Second, if it is a cash offer to purchase almost
all of the assets from the target, then it is a taxable purchase of assets with a specific set of
tax rules. Third, if it is a cash offer to purchase shares from the target’s stockholders, then
it is a taxable purchase of shares with a different set of tax rules. The following sections
explain the tax treatment for mergers in these three categories. (Figure 22-3 is a flowchart
of the tax treatments.) The sections also explain the impact of the 2017 TCJA on mergers.

22-13a Nontaxable Exchange of Stock

In a nontaxable deal, target shareholders who receive shares of the acquiring company’s
stock do not have to pay any taxes at the time of the merger. This also applies if the offer
is a mix of cash and stock, so long as the offer is mostly stock. However, if the payment
includes a significant amount of cash or bonds, then the IRS views it as a sale, and it is a
taxable offer.
Shareholders receiving stock in a nontaxable exchange pay taxes only when they even-
tually sell their stock. 23 The amount of the gain is the sale price of their stock in the

20
For details, see Jeffrey W. Allen, Scott L. Lummer, John J. McConnell, and Debra K. Reed, “Can Takeover
Losses Explain Spin-off Gains?” Journal of Financial and Quantitative Analysis, December 1995, pp. 465–485.
21
See Shane A. Johnson, Daniel P. Klein, and Verne L. Thibodeaux, “The Effects of Spin-offs on Corporate Invest-
ment and Performance,” Journal of Financial Research, Summer 1996, pp. 293–307. Also see Steven Kaplan and
Michael S. Weisbach, “The Success of Acquisitions: Evidence from Divestitures,” Journal of Finance, March
1992, pp. 107–138.
22
For more details, see J. Fred Weston, Mark L. Mitchell, and Harold Mulherin, Takeovers, Restructuring,
and Corporate Governance, 4th ed. (Upper Saddle River, NJ: Prentice-Hall, 2004), especially Chapter 4. Also
see Kenneth E. Anderson, Thomas R. Pope, and John L. Kramer, eds., Prentice Hall’s Federal Taxation 2017:
Corporations, Partnerships, Estates, and Trusts, 30th ed. (Upper Saddle River, NJ: Prentice-Hall, 2017),
especially Chapter 7.
23
This is a capital gain if it has been at least 1 year since they purchased their original stock in the target.

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
882 Part 9 Strategic Finance in a Dynamic Environment

FIGURE 22-3
Merger Tax Effects

Target:
Shareholders receive shares of
stock in the acquiring firm.
Mostly Acquiring firm:
Payment in 1. Adds acquired assets to its
stock Non-taxable books at book value.
cash or
exchange 2. Continues depreciating
stock?
acquired assets at old rate
even if appraised value differs
from book value.
3. Goodwill is not created
for tax purposes.
Mostly
cash Target:
1. Target incurs immediate
tax liability for amount of
gain (purchase price over
book value).
Taxable 2. Target distributes the amount
Purchase remaining after taxes to its
purchase of shareholders as a liquidating
of assets
assets or stock? dividend.
3. Target shareholders pay
personal taxes on dividends
received..
Acquiring firm:
Purchase 1. Adds acquired assets to
of stock its books at appraised value.
2. Creates goodwill that
can be depreciated for tax
purposes.

Record asset Record assets at

Record assets
at appraised appraised value
at book value
value or book value?

Target:
Target: Target stockholders tender
1. Target stockholders their shares, receive cash,
tender their shares, receive and pay personal taxes on
cash, and pay personal taxes any gains.
on any gains.
2. Target incurs immediate Acquiring firm:
tax liability for amount of 1. Adds acquired assets to its
gain (appraised value over books at book value.
book value). 2. Continues depreciating
acquired assets at old rate
Acquiring firm: even if appraised value differs
1. Adds acquired assets to from book value.
its books at appraised value. 3. Goodwill is not created
2. Creates goodwill that for tax purposes.
can be depreciated for tax
purposes.
3. Is ultimately responsible
for the tax liability incurred
by the target since it
owns the target.

Note:
These are actual cash tax effects. However, the tax effects reported to shareholders will be different because
shareholder statements must conform to GAAP conventions, not to federal Tax Code conventions.

acquiring company minus the price at which they purchased their original stock in the
target company.
All else equal, stockholders prefer nontaxable offers because they can postpone taxes
on their gains. Furthermore, if the target firm’s stockholders receive stock, they will benefit
from any synergistic gains produced by the merger. Most target shareholders are thus will-
ing to give up their stock for a lower price in a nontaxable offer than in a taxable one. As a

result, one might expect nontaxable bids to dominate. However, this is not the case: Roughly
half of all mergers have been taxable. We explain why this is so by way of an example.
To keep the example simple, we assume the target has no debt. Suppose the target firm
has assets with a book value of $100 million and an appraised value of $150 million. The
stock offer by the acquiring firm is worth $220 million to the target’s shareholders, and no
tax is due until a shareholder sells his or her shares.
The acquiring firm simply adds the $100 million book value of the target’s assets to
its own assets and continues to depreciate the acquired assets using the target’s exist-
ing depreciation schedule. Therefore, the acquirer might get a very small depreciation tax
shield, especially if the target’s assets are old. This is in contrast to larger depreciation tax
shields that can result from other acquisition methods described in the following sections.

22-13b Taxable Purchase of Assets

If an offer is to purchase the target’s assets, then the target’s board of directors will evalu-
ate the offer to determine whether the offer price is acceptable. If so, the board will rec-
ommend that shareholders vote to accept the offer; otherwise, they will recommend that
shareholders reject the offer. The board’s recommendation is not binding, and sharehold-
ers may vote as they choose.
If the shareholders accept the offer, the payment goes directly to the target corpora-
tion, which pays off any debt not assumed by the acquiring firm. The target firm pays cor-
porate taxes on any gains that are due if the assets are sold for more than their book values.
The target then distributes the remainder of the payment to the shareholders, often in the
form of a liquidating dividend. The target firm is usually dissolved and no longer contin-
ues to exist as a separate legal entity, although its assets and workforce may continue to
function as a division or as a wholly owned subsidiary of the acquiring firm. The acquisi-
tion of assets is a common form of takeover for small and medium-sized firms, especially
those that are not publicly traded.
To illustrate the tax effects, suppose the acquirer in the previous example purchases
the target’s assets for $220 million instead of merging through an exchange of stock. The
target’s assets have a book value of $100 million, so the target firm must pay corporate tax
on the $120 million gain: $220 − $100 5 $120. Assuming the combined federal-plus-state
corporate tax rate is 25%, this target will owe $30 million in taxes: 0.25($120) 5 $30.
This leaves the target with $190 million ($220 − $30 5 $190) to distribute to its share-
holders upon liquidation. The target’s shareholders must also pay individual taxes on any
of their own gains.24 Recall from Chapter 2 that the tax rate on dividends for high-income
individuals is 20%.25 There is also the 3.8% Net Investment Income Tax (NIIT) on personal
investment income. Therefore, the target’s shareholders must pay taxes of $45.22 million:
$190(20% 1 3.8%) 5 $45.22. The total corporate tax and personal tax equals $75.22 million:
$30 1 $45.22 5 $75.22. Therefore, the effective tax rate to the shareholders is 34.2%:
$75.22/$220 5 34.2%. When we called this a taxable transaction, we weren’t kidding!
In contrast to the selling firm’s shareholders, the acquiring firm receives large tax
benefits. First, the buyer adds the appraised value to its books and can depreciate this
amount as though it is new property. This is not a new benefit for purchasers, but the TCJA
made it even more valuable by allowing companies to depreciate 100% of the purchase in

24
Our example assumes that the target is a publicly owned firm, which means that it must be a C corporation
for tax purposes. However, if it is privately held, then it might be an S corporation, in which case only the stock-
holders would be taxed. This helps smaller firms use mergers as an exit strategy.
25
See Web Extension 2A for an explanation of the tax rate on dividends if the recipient does not have a
high-income.

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884 Part 9 Strategic Finance in a Dynamic Environment

2018–2022. This can significantly reduce taxable income and create large tax savings for
the acquiring firm. Although firms cannot deduct 100% of the purchase price after 2022,
the TCJA still provides generous first-year depreciation through 2026.26
Second, the acquirer records the difference between the purchase price and the
appraised value in an asset account called goodwill. In the following sections, we explain
the impact of goodwill on financial statements, but here we focus on taxes. The IRS allows
an acquirer to amortize goodwill over 15 years using the straight-line method and then
deduct the annual amortization expense from the taxable income it reports to the IRS.
We use the previous example to illustrate the acquirer’s tax benefits. If the acquisi-
tion is completed before 2023, the acquirer will be able to deduct the full appraised value
as bonus depreciation. Thus, it will immediately depreciate $150 million of assets. If the
federal-plus-state corporate tax rate is 25%, then the acquirer will save $37.5 million in
federal taxes by using bonus depreciation: 25%($150) 5 $37.5. In addition, the acquirer will
be able to deduct $6.7 million in amortization expenses each year: $100/15 5 $6.67. This
deduction will reduce taxes in each of the next 15 years by $1.67 million: 25%($6.67) 5 $1.4.
Recall that in a stock purchase, the acquirer can only continue to depreciate the
$100 million of book value using the target’s existing depreciation schedule. As explained
previously, the tax savings to the acquirer might be quite small.

22-13c Taxable Purchase of Shares

An offer for a target’s stock rather than its assets can be made either directly to the share-
holders, as is typical in a hostile takeover, or indirectly through the board of directors,
which in a friendly deal makes a recommendation to the shareholders to accept the offer.
In a successful offer, the acquiring firm will end up owning a controlling interest or per-
haps even all the target’s stock. Sometimes the target retains its identity as a separate legal
entity and is operated as a subsidiary of the acquiring firm, and sometimes its corporate
status is dissolved, and it is operated as one of the acquiring firm’s divisions.
The acquirer can choose to record the target’s assets at their book values or at their
appraised values. Either way, the target shareholders must pay taxes on any gains. However,
the methods differ with respect to the target firm’s and the acquiring firm’s tax treatments.

RECORD ASSETS AT BOOK VALUES

If the acquirer records the assets at their book values, then the acquirer continues to
depreciate the acquired assets according to their previous depreciation schedules. Good-
will is not treated as a deductible expense. Note that the acquiring firm’s tax treatment is
the same as in Section 22-13a, in which the acquisition is by means of a stock exchange.
As explained earlier, the annual tax deductions are relatively small for assets with long
remaining lives.

RECORD ASSETS AT APPRAISED VALUES

If the acquirer records the assets at their appraised values, then the target incurs a tax
liability for the difference between the appraised value and the book value. The acquiring
firm will be responsible for this liability and pays these taxes after completing the acquisi-
tion. In contrast to this tax liability, the acquiring firm also receives a benefit because it
can fully depreciate the appraised values of the assets and can deduct goodwill expenses
from its taxable income.

26
After 2022, the amount of the bonus depreciation in the first year falls by 20% per year: 80% in 2023, 60% in
2024, 40% in 2025, 20% in 2026, and 0% in 2027. This means that acquisitions will create significant tax savings
for years to come.

S E L F -T E S T

What are three types of mergers regarding taxes?

How are targets and acquirers taxed in each type of merger?

22-14 Financial Reporting for Mergers

Although a detailed discussion of financial reporting is best left to accounting courses,
the accounting implications of mergers cannot be ignored. Currently, mergers are han-
dled using purchase accounting.27 Keep in mind, however, that all large companies are
required to keep two sets of books. The first is for the IRS, and it reflects the tax treatment
of mergers as described in the previous section. The second is for financial reporting, and
it reflects the treatment described here. As you will see, the rules for financial reporting
differ from those for the IRS.

22-14a Purchase Accounting

Table 22-1 illustrates purchase accounting. Here, Firm A is assumed to have “bought” Firm
B using A’s stock. If the price paid is exactly equal to the acquired firm’s net asset value,
which is defined as its total assets minus its liabilities, then the consolidated balance sheet
will be as if the two statements were combined into one. Normally, though, there is an
important difference. If the price paid exceeds the net asset value, then asset values will be

TABLE 22-1
Accounting for Mergers: Firm A Acquires Firm B with Stock

Post-Merger: Firm A
a
Firm A Firm B $20 Paid $30 Paida $50 Paida
(1) (2) (3) (4) (5)

Current assets $ 50 $25 $ 75 $ 75 $ 80b

Fixed assets 50 25 65c 75 80b
d
Goodwill 0 0 0 0 10d
Total assets $100 $50 $140 $150 $170
Liabilities $ 40 $20 $ 60 $ 60 $ 60
Equity 60 30 80e 90 110f
Total claims $100 $50 $140 $150 $170
Notes:
a
The price paid is the net asset value—that is, total assets minus liabilities.
b
Here we assume that Firm B’s current and fixed assets are both increased to $30.
c
Here we assume that Firm B’s fixed assets are written down from $25 to $15 before constructing the consolidated
balance sheet.
d
Goodwill refers to the excess paid for a firm above the appraised value of the physical assets purchased. Goodwill
represents payment both for intangibles such as patents and for “organization value,” such as that associated
with having an effective sales force. Beginning in 2001, purchased goodwill such as this may not be amortized for
financial statement reporting purposes.
e
Firm B’s common equity is reduced by $10 prior to consolidation to reflect the fixed asset write-off.
f
Firm B’s equity is increased to $50 to reflect the above-book purchase price.

27
In 2001, the Financial Accounting Standards Board (FASB) issued Statement 141, which eliminated the use
of pooling accounting.

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886 Part 9 Strategic Finance in a Dynamic Environment

increased to reflect the price actually paid, whereas if the price paid is less than the net asset
value, then assets must be written down when preparing the consolidated balance sheet.
Note that Firm B’s net asset value is $30, which is also its reported common equity
value. This $30 book value could be equal to the market value (which is determined by
investors based on the firm’s earning power), but book value could also be more or less
than the market value. Three situations are considered in Table 22-1. First, in Column 3
we assume that Firm A gives stock worth $20 for Firm B. Thus, B’s assets as reported on its
balance sheet were overvalued, and A pays less than B’s net asset value. The overvaluation
could be in either fixed or current assets; an appraisal would be made, but we assume it is
fixed assets that are overvalued. Accordingly, we reduce B’s fixed assets and also its com-
mon equity by $10 before constructing the consolidated balance sheet shown in Column
3. Next, in Column 4, we assume that A pays exactly the net asset value for B. In this case,
the financial statements are simply combined.
Finally, in Column 5 we assume that A pays more than the net asset value for B: $50 is
paid for $30 of net assets. This excess is assumed to be partly attributable to undervalued
assets (land, buildings, machinery, and inventories) and so, to reflect this undervaluation,
current and fixed assets are each increased by $5. In addition, we assume that $10 of the
$20 excess of market value over book value is due to a superior sales organization or to
some other intangible factor, and we post this excess as goodwill. Firm B’s common equity
is increased by $20, the sum of the increases in current and fixed assets plus goodwill, and
this markup is also reflected in Firm A’s post-merger equity account.28

22-14b Income Statement Effects

A merger can have a significant effect on reported profits. If asset values are increased, as
they often are under a purchase, then this must be reflected in higher depreciation charges
(and also in a higher cost of goods sold if inventories are written up). This, in turn, will
reduce reported profits. For financial reporting, but not for taxes, goodwill is subject to an
annual impairment test. If the estimated fair market value of the goodwill has declined (i.e.,
been impaired) over the year, then the amount of the decline must be reported as an expense.
However, if the goodwill’s estimated fair market goes up, it cannot be reported as income.
re source Table 22-2 illustrates the income statement effects of the write-up of current and fixed
See Ch22Tool Kit.xlsx on assets. We assume A purchased B for $50, creating $10 of goodwill and $10 of higher physi-
the textbook’s Web site
for details.
cal asset value. As Column 3 indicates, the asset markups cause reported profits to be
lower than the sum of the individual companies’ reported profits because of the increased
depreciation expense and the increased cost of goods sold.
The asset markup is also reflected in earnings per share. In our hypothetical merger,
we assume that nine shares exist in the consolidated firm. (Six of these shares went to A’s
stockholders, and three went to B’s.) The merged company’s EPS is $2.92, whereas each of
the individual companies’ EPS was $3.00.

S E L F -T E S T

What is purchase accounting for mergers?

What is goodwill? What impact does goodwill have on the firm’s balance sheet? On its income
statement?

28
This example assumes that additional debt was not issued to help finance the acquisition. If the acquisition
were totally debt financed, then the post-merger balance sheet would show an increase in debt rather than an
increase in the equity account. If it were financed by a mix of debt and equity, both accounts would increase. If
the acquisition were paid for with cash on hand, then current assets would decrease by the amount paid, and
the equity account would not increase.

TABLE 22-2
Income Statement Effects

Pre-Merger Post-Merger: Firm A

Firm A Firm B Merged
(1) (2) (3)

Sales $ 100.0 $ 50.0 $150.00

Operating costs 72.0 36.0 109.00a
Operating income $ 28.0 $ 14.0 $ 41.00a
Interest (10%) 4.0 2.0 6.00
Taxable income $ 24.0 $ 12.0 $ 35.00
Taxes (25%) 6.0 3.0 8.75
Net income $ 18.0 $ 9.0 $ 26.25
EPSb $ 3.00 $ 3.00 $ 2.92
Notes:
a
Operating costs are $1 higher than they otherwise would be; this reflects the higher reported costs (depreciation
and cost of goods sold) caused by the physical asset markup at the time of purchase.
b
Before the merger, Firm A had six shares and Firm B had three shares. Firm A gives one of its shares for each of Firm
B’s, so A has nine shares outstanding after the merger.

SUMMARY
●
A merger occurs when two firms combine to form a single company. The primary
motives for mergers are (1) synergy, (2) tax considerations, (3) purchase of assets below
their replacement costs, (4) diversification, (5) gaining control over a larger enterprise,
and (6) breakup value.
●
Mergers can provide economic benefits through economies of scale and through
putting assets in the hands of more efficient managers. However, mergers also have the
potential for reducing competition, and for this reason they are carefully regulated by
government agencies.
●
In most mergers, one company (the acquiring company) initiates action to take over
another (the target company).
●
A horizontal merger occurs when two firms in the same line of business combine.
●
A vertical merger combines a firm with one of its customers or suppliers.
●
A congeneric merger involves firms in related industries but where no customer–
supplier relationship exists.
●
A conglomerate merger occurs when firms in totally different industries combine.
●
In a friendly merger, the managements of both firms approve the merger, whereas in a
hostile merger, the target firm’s management opposes it.
●
An operating merger is one in which the operations of the two firms are combined.
A financial merger is one in which the firms continue to operate separately; hence, no
operating economies are expected.
●
In a typical merger analysis, the key issues to be resolved are (1) the price to be
paid for the target firm and (2) the employment/control situation. If the merger is a
consolidation of two relatively equal firms, at issue is the percentage of ownership that
each merger partner’s shareholders will receive.

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888 Part 9 Strategic Finance in a Dynamic Environment

●
Four methods are commonly used to determine the value of the target firm: (1) market
multiple analysis, (2) the free cash flow corporate valuation model, (3) the free cash
flow to equity (FCFE) model, and (4) the compressed adjusted present value (CAPV)
model. Of the discounted cash flow approaches, only the compressed APV model is
appropriate if the capital structure is changing during the forecast period.
●
Purchase accounting treats mergers as a purchase and is used for financial reporting.
●
A joint venture is a corporate alliance in which two or more companies combine
some of their resources to achieve a specific, limited objective.
●
A divestiture is the sale of some of a company’s operating assets. A divestiture may
involve (1) selling an operating unit to another firm, (2) spinning off a unit as a
separate company, (3) carving out a unit by selling a minority interest, or (4) the
outright liquidation of a unit’s assets.
●
The reasons for divestiture include (1) settling antitrust suits, (2) improving the
transparency of the resulting companies so that investors can more easily evaluate
them, (3) enabling management to concentrate on a particular type of activity, and
(4) raising the capital needed to strengthen the corporation’s core business.
●
A holding company is a corporation that owns sufficient stock in another firm to
control it. The holding company is also known as the parent company, and the
companies that it controls are called subsidiaries or operating companies.
●
Holding company operations are advantageous because: (1) Control can often be obtained
for a smaller cash outlay. (2) Risks may be segregated. (3) Regulated companies can
operate separate subsidiaries for their regulated and unregulated businesses.
●
The main disadvantage of a holding company is partial multiple taxation of dividends
in which the holding company’s shareholders are taxed on dividends received from
the holding company, which itself might be taxed on dividends received from the
operating companies.

QUESTIONS

( 2 2-1) Define each of the following terms:

a. Synergy; merger
b. Horizontal merger; vertical merger; congeneric merger; conglomerate merger
c. Friendly merger; hostile merger; defensive merger; tender offer; target company;
breakup value; acquiring company
d. Operating merger; financial merger
e. Purchase accounting
f. White knight; proxy fight
g. Joint venture; corporate alliance
h. Divestiture; spin-off
i. Holding company; operating company; parent company
j. Arbitrage; risk arbitrage
(2 2-2) Four economic classifications of mergers are (1) horizontal, (2) vertical, (3) conglomerate,
and (4) congeneric. Explain the significance of these terms in merger analysis with regard to
(a) the likelihood of governmental intervention and (b) possibilities for operating synergy.
( 2 2-3) Firm A wants to acquire Firm B. Firm B’s management agrees that the merger is a good idea.
Might a tender offer be used? Why or why not?
( 2 2- 4 ) Distinguish between operating mergers and financial mergers.
( 2 2-5 ) Explain why the APV model is suited for situations in which the capital structure is changing
during the forecast period.

SELF-TEST PROBLEM SOLUTION SHOWN IN APPENDIX A

( S T-1) Red Valley Breweries is considering an acquisition of Flagg Markets. Flagg currently has
Valuation of Target a cost of equity of 10%; 25% of its financing is in the form of 6% debt, and the rest is in
common equity. Its federal-plus-state tax rate is 25%. After the acquisition, Red Valley
expects Flagg to have the FCFs and interest payments for the next 3 years (in millions)
shown in the following table. After the explicit forecast period, the free cash flows are
expected to grow at a constant rate of 5%, and the capital structure will stabilize at 35%
debt with an interest rate of 7%. Use the compressed adjusted present value approach to
answer the following questions.

Year 1 Year 2 Year 3

FCF $10.00 $20.00 $25.00
Interest expense 28.00 24.00 20.28

a. What is Flagg’s unlevered cost of equity? What are its levered cost of equity and cost
of capital for the post-horizon period?
b. What is Flagg’s value of operations to Red Valley?

PROBLEMS ANSWERS ARE IN APPENDIX B

EASY PROBLEMS 1–3

( 2 2-1) Elliott’s Cross Country Transportation Services has a capital structure with 25% debt at
Unlevered Cost a 9% interest rate. Its beta is 1.6, the risk-free rate is 4%, and the market risk premium is
of Equity
7%. Elliott’s combined federal-plus-state tax rate is 25%.
a. What is Elliott’s cost of equity?
b. What is its weighted average cost of capital?
c. What is its unlevered cost of equity?
( 2 2-2 ) Richter Manufacturing has a 10% unlevered cost of equity. Richter forecasts the
Unlevered Value following free cash flows (FCFs), which are expected to grow at a constant 3% rate
after Year 3.

Year 1 Year 2 Year 3

FCF $715 $750 $805

a. What is the horizon value of the unlevered operations?

b. What is the total value of unlevered operations at Year 0?
( 2 2-3) Wilde Software Development has a 12% unlevered cost of equity. Wilde forecasts the
Tax Shield Value following interest expenses, which are expected to grow at a constant 4% rate after
Year 3. Wilde’s tax rate is 25%.

Year 1 Year 2 Year 3

Interest expenses $80 $100 $120

a. What is the horizon value of the interest tax shield?

b. What is the total value of the interest tax shield at Year 0?

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890 Part 9 Strategic Finance in a Dynamic Environment

INTERMEDIATE PROBLEMS 4 –5
( 2 2- 4 ) Hasting Corporation is interested in acquiring Vandell Corporation. Vandell has
Intrinsic Value of 1.5 million shares outstanding and a target capital structure consisting of 30% debt;
Merger Target
its beta is 1.4 (given its target capital structure). Vandell has $10.19 million in debt that
trades at par and pays an 8% interest rate. Vandell’s current free cash flow (FCF0) is
$2 million per year and is expected to grow at a constant rate of 5% a year. Vandell
pays a 25% combined federal-plus-state tax rate, the same rate paid by Hastings. The
risk-free rate of interest is 5%, and the market risk premium is 6%. Hasting’s first step is
to estimate the current intrinsic value of Vandell.
a. What is Vandell’s cost of equity?
b. What is its weighted average cost of capital?
c. What is Vandell’s intrinsic value of operations? (Hint: Use the free cash flow corpo-
rate valuation model from Chapter 7.)
d. Based on this analysis, what is the minimum stock price that Vandell’s shareholders
should accept?
( 2 2-5 ) Hasting Corporation estimates that if it acquires Vandell Corporation, synergies
Merger Valuation will cause Vandell’s free cash flows to be $2.5 million, $2.9 million, $3.4 million, and
with Synergies
$3.57 million at Years 1 through 4, respectively, after which the free cash flows will
grow at a constant 5% rate. Hasting plans to assume Vandell’s $10.19 million in debt
(which has an 8% interest rate) and raise additional debt financing at the time of
the acquisition. Hastings estimates that interest payments will be $1.5 million each
year for Years 1, 2, and 3. After Year 3, a target capital structure of 30% debt will be
maintained. Interest at Year 4 will be $1.472 million, after which the interest and
the tax shield will grow at 5%. As described in Problem 22-4, Vandell currently has
1.5 million shares outstanding and a target capital structure consisting of 30% debt;
its current beta is 1.4 (i.e., based on its target capital structure). Vandell and Hastings
each have a 25% combined federal-plus-state tax rate. The risk-free rate is 5% and the
market risk premium is 6%.
a. What is Vandell’s pre-acquisition levered cost of equity? What is its unlevered cost
of equity? (Hint: You can use the pre-acquisition levered cost of equity you deter-
mined previously if you worked Problem 22-1.)
b. What is the intrinsic unlevered value of operations at t 5 0 (assuming the synergies
are realized)?
c. What is the value of the tax shields at t 5 0?
d. What is the total intrinsic value at t 5 0? What is the intrinsic value of Vandell’s
equity to Hasting? What is the maximum price per share that Hasting’s should offer
Vandell’s shareholders?

CHALLENGING PROBLEM 6
( 2 2- 6 ) Crane Rafting Corporation is considering an acquisition of Frost Ski Supplies. Frost has
Impact of Synergies a pre-merger 8% unlevered cost of equity, 6% pre-tax cost of debt, and 25% tax rate. Its
and Capital
pre-merger forecasted free cash flows and debt are expected to grow at a constant 5% rate
Structure Changes
after Year 4. Frost has 800 million outstanding shares.
If Crane makes the acquisition, synergies will increase Frost’s free cash flows.
Crane will also add debt at Frost’s 6% rate. Crane’s tax rate is 25%. The post-merger
forecasted free cash flows and debt are expected to grow at a constant 5% rate
after Year 4.

Data for Frost’s pre-merger and post-merger FCF and debt are shown here:
Frost: Pre-merger Year 0 Year 1 Year 2 Year 3 Year 4
FCF (millions) $1,400 $1,600 $1,800 $1,900 $2,000
Debt (millions) $7,700 $7,900 $8,100 $8,200 $8,300

Frost: Post-merger Year 0 Year 1 Year 2 Year 3 Year 4

FCF (millions) $1,400 $1,700 $2,000 $2,100 $2,200
Debt (millions) $7,700 $22,000 $22,300 $22,400 $22,500

a. What is Frost’s pre-merger unlevered horizon value? What is its Year-0 unlevered
value?
b. What is Frost’s pre-merger horizon value tax shield? What is its Year-0 tax shield
value? Assume debt is added on the first day of the year; that is, calculate interest
expenses for Year t based on debt at Year t.
c. What is Frost’s current value of levered operations? What is its value of equity?
What is the minimum stock price per share that Frost’s shareholders should accept?
d. What is Frost’s post-merger unlevered horizon value to Crane? What is its Year-0
unlevered value?
e. What is Frost’s post-merger horizon value tax shield to Crane? What is its Year-0
tax shield value? Assume debt is added on the first day of the year; that is, calculate
interest expenses for Year t based on debt at Year t.
f. What is Frost’s post-merger Year-0 value of levered operations to Crane? What is
its value of equity? (Hint: Remember that Crane assumes Frost’s debt and subse-
quently issues more debt.) What is the maximum stock price per share that Crane
should offer?
g. What percentage of Frost’s pre-merger capital structure at Year 4 consisted of debt?
(Hint: You already have the values you need to calculate the total value at the hori-
zon.) What percentage after the merger? How much of Frost’s post-merger increase
in value to Crane is due to improved FCF? (Hint: You already have calculated the
values you need to determine the answer to this question.) How much is due to the
change in capital structure?

SPREADSHEET PROBLEM

( 2 2-7 ) Start with the partial model in the file Ch22 P07 Build a Model.xlsx on the textbook’s
Build a Model: Web site. Wansley Portal Inc., a large Internet service provider, is evaluating the
Merger Analysis
possible acquisition of Alabama Connections Company (ACC), a regional Internet
re source service provider. Wansley’s analysts project the following post-merger data for ACC
(in thousands of dollars):
2020 2021 2022 2023 2024
Net sales $500 $600 $700 $760 $806
Selling and administrative expense 60 70 80 90 96
Interest 30 40 45 60 74
If the acquisition is made, it will occur on January 1, 2020. All cash flows shown in the
income statements are assumed to occur at the end of the year. ACC currently has a
capital structure of 30% debt, which costs 9%, but Wansley would increase that over
time to 40%, costing 10%, if the acquisition were made. ACC, if independent, would pay

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
892 Part 9 Strategic Finance in a Dynamic Environment

taxes at 25%, and its income would be taxed at 25% if it were consolidated. ACC’s current
market-determined beta is 1.4. The cost of goods sold, which includes depreciation,
is expected to be 65% of sales. Required gross investment in operating capital is
approximately equal to the depreciation charged, so there will be no investment in net
operating capital. The risk-free rate is 7%, and the market risk premium is 6.5%. Wansley
currently has $400,000 in debt outstanding. Use the compressed APV model to answer
the following questions.
a. What is the unlevered cost of equity?
b. What are the horizon value of the tax shields and the horizon value of the unlevered
operations? What are the value of ACC’s operations and the value of ACC’s equity to
Wansley’s shareholders?

MINI CASE

Hager’s Home Repair Company, a regional hardware chain, which specializes in “do-it-
yourself” materials and equipment rentals, is considering an acquisition of Lyon Light-
ing (LL). Doug Zona, Hager’s treasurer and your boss, has been asked to place a value on
the target and he has enlisted your help.
LL has 20 million shares of stock trading at $12 per share. Security analysts estimate
LL’s beta to be 1.25. The risk-free rate is 5.5% and the market risk premium is 4%. LL’s
capital structure is 20% financed with debt at an 8% interest rate; any additional debt
due to the acquisition also will have an 8% rate. LL has a 25% federal-plus-state tax rate,
which will not change due to the acquisition.
The following data incorporate expected synergies and required levels of total net
operating capital for LL should Hager’s complete the acquisition. The forecasted inter-
est expense includes the combined interest on LL’s existing debt and on new debt. After
2024, all items are expected to grow at a constant 6% rate.
2019 2020 2021 2022 2023 2024
Net sales $150 $170 $186 $200 $212
Cost of goods sold $116 $128 $135 $148 $160
Selling/administrative expense $ 22 $ 26 $ 27 $ 28 $ 32
Total net operating capital $64 $ 75 $ 85 $ 93 $100 $106
a
Debt $30 $ 50 $ 52 $ 52 $ 53 $ 54
Note:
a
Debt is added on the first day of the year, so the 2019 debt is LL’s debt prior to the acquisition.

Hager’s management is new to the merger game, so Zona has been asked to answer
some basic questions about mergers as well as to perform the merger analysis. To struc-
ture the task, Zona has developed the following questions, which you must answer and
then defend to Hager’s board:
a. Several reasons have been proposed to justify mergers. Among the more prominent
are (1) synergy, (2) tax considerations, (3) breakup value, (4) risk reduction through
diversification, (4) purchase of assets at below-replacement cost, and (5) managerial
incentives. In general, which of the reasons are economically justifiable? Which
are not?
b. Briefly describe the differences between a hostile merger and a friendly merger.
c. What are the steps in valuing a merger using the compressed APV approach?

d. Why can’t we estimate LL’s value to Hager’s by discounting the FCFs at the WACC?
What method is appropriate? Use the projections and other data to determine the
LL division’s free cash flows and interest tax savings for 2020 through 2024. Notice
that the LL division’s sales are expected to grow rapidly during the first years before
leveling off at a sustainable long-term growth rate.
e. Conceptually, what is the appropriate discount rate to apply to the cash flows devel-
oped in part d? What is your actual estimate of this discount rate?
f. What is the estimated unlevered horizon value? What is the current unlevered
operating value? What is the horizon value of the interest tax savings? What is the
current value of the interest tax savings? What is the current total value of the acqui-
sition to Hager’s shareholders? Suppose another firm were evaluating Lyon Lighting
as an acquisition candidate. Would they obtain the same value? Explain.
g. Should Hager’s make an offer for Lyon Lighting? If so, how much should it offer per
share?
h. Considerable research has been undertaken to determine whether mergers really
create value and, if so, how this value is shared between the parties involved. What
are the results of this research?
i. What method is used to account for mergers?
j. What merger-related activities are undertaken by investment bankers?
k. What are the major types of divestitures? What motivates firms to divest assets?
l. What are holding companies? What are their advantages and disadvantages?

SELECTED ADDITIONAL CASES

The following cases from CengageCompose cover many of the concepts discussed in this
chapter and are available at http://compose.cengage.com.
Klein-Brigham Series:
Case 40, “Nina’s Fashions, Inc.”; Case 53, “Nero’s Pasta, Inc.”; and Case 70, “Computer
Concepts/CompuTech.”

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