Mergers

H - Merger and acquisition approach

Business combinations take place because both businesses see their value increase as a result of the combination. Note that, in principle and according to portfolio theory, the combination adds little to owners (i.e. shareholders) if it is strictly for the purpose of diversification or expansion of sales because shareholders can achieve diversification or earnings expansion by buying shares of the two autonomous companies. The combination must result in some additional cost saving or revenue generating opportunity. These can come, for instance, from integrating complementary new technologies, ability to serve same target clients simultaneously or taking advantage of economies of scale of production.

From an accounting point of view, a true merger is known as pooling of interests in the United States, which involves two companies of comparable size, and in which the shareholders of the two previous companies are treated equally. In all other combinations, an acquisition of one company by the other takes place. In general, it has been observed that the stock market tends to penalize the acquiring company because it perceives an acquisition as an added risk, and because the acquiring company has to pay the existing shareholders a premium to let go of their stock. Conversely, the acquired company is seen by the stock market in a positive light, and its share price goes up because an acquisition of the company is an indication that the acquired company has an added value beyond the value perceived by the market now, and because its shareholders are likely to receive a premium for their shares. (The phenomenon that a stock price is swollen by another company's attempt to acquire the company, can be observed each time an unsuccessful take-over bid is rejected, and the stock price of the company to be acquired drops immediately.)

The value of a company to be acquired is essentially that of an owner (as it will be further discussed in the last section). But what is of interest in the situation of this section, is that the acquiring company does not yet own the company it plans to acquired. It has other alternatives and opportunities. The financial analytical process must therefore take these opportunities into consideration. There is, in fact, an entire strategy that emerges in the process of business combinations.

The strategy for the acquiring company may include the following phases:
- a preacquisition phase in which an acquirer must evaluate itself and identify external opportunities which justify the need for an acquisition,
- a screening of candidates in which the acquirer considers various alternatives including creating its own affiliate from scratch and using investment banks to arrange for the acquisition,
- a valuation of the best alternative, that includes a recognition of need to pay a premium, identifying real instances of synergy, and planning to shed some assets,
- a negotiation with due consideration for third parties, other acquisition alternatives, potential refusal to be acquired on the part of current management, and that "all is not known about the acquired company",
- a preparation for post acquisition strategy to integrate the newly acquired company into the operations of the parent company.

The value of the acquired company is normally the discounted net (and new) cash flows. Cash flows (and not earnings as in the case of outside shareholders) are discounted and summed because the acquiring company will have at its disposal the additional internal reinvestment potential stemming from non-cash expenses of the acquired company. The discount rate to be used is also not the return to shareholders, but the average cost of capital of the acquired company because it is the appropriate rate of return for this industry and this management. For each potential company that can be considered for acquisition, the discount rate reflects specific circumstances of company and industry.

The discounted cash flows evaluation requires meticulous projections of sales growth within the planned combined structure. Additional corrections should also be made for the competitive position of the combined company within the industry. Usually, a premium over the value of the assets is assigned for 1) goodwill (i.e. customers) of the acquired company, as well as 2) other intangible assets (i.e. technological or managerial know-how, sometimes called human capital). Recognition of these two elements is often presented as a justification for the premium over current market price paid to the existing shareholders of the acquired company by the acquiring company.

In some cases the acquired company is purchased because the value of some of its assets is underpriced within that company. That may be the case of some rare raw materials left unutilized, mining reserves, tax loss carryforward, or idle liquidity. The acquiring company may generate its cash flows by disposing of some of these assets while using those that it deems beneficial. Plant closing are not uncommon when business combinations occur. The liquidating value of the assets disposed of is entered into cash flow calculation, occasionally reduced by costs of selling or closing operations. When equipment of the acquired company can be used to replace equipment of the acquiring company, then, the replacement value of such assets should be used but not the cash flows from using these assets because they would be generated even without the merger.

After giving recognition for the above elements, the adjusted discounted cash flow value is reduced by acquired company debt that must be taken over. The net amount is then marked down for lack of marketability if it is a small company whose shares are not easily traded on an exchange. The mark down can be 5% to 10% for a company with total capitalization in excess of $20 million, 33% for a capitalization of $1 to $5 million, and 40% or more for smaller closely held corporations.

Many companies that dominate their industry, achieve their position through acquisitions (witness the evolution of the automobile industry used as an example in the study of industry evolution in Chapter 14 Section B-2 and subsequent). Yet mispricing of purchased companies is common and occasionally spectacular. For instance, the purchase of Rover by BMW is reported in The Economist of ---, 2001 as a flagrant overpayment of $4.5 billions. A mistake in evaluating future cash flows was caused by an underestimation of the loss of market position of Rover models and poor post acquisition strategy of BWM. Another sour acquisition reported in the same issue of The Economist is that of Chrysler by Mercedes. The lesson from these examples points to the importance and difficulties of financial analysis of potential corporate acquisitions.

See review questions Q-4H.1 through Q-4H.11.

See research assignments R-4.24 and R-4.25.

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