Chapter 20 - External Growth through Mergers
Chapter 20
External Growth through Mergers
Discussion Questions
20-1.
Name three industries in which mergers have been prominent.
Computers, telecommunications, public utilities, pharmaceuticals, and energy.
What is the difference between a merger and a consolidation?
In a merger, two or more companies are combined, but only the identity of the acquiring firm is maintained. In a consolidation, an entirely new entity is formed from the combined companies.
Why might the portfolio effect of a merger provide a higher valuation for the participating firms?
If two firms benefit from opposite phases of the business cycle, their variability in performance may be reduced. Risk-averse investors may then discount the future performance of the merged firms at a lower rate and thus assign a higher valuation than was assigned to the separate firms.
What is the difference between horizontal integration and vertical integration? How does antitrust policy affect the nature of mergers?
Horizontal integration is the acquisition of competitors, and vertical integration is the acquisition of companies that produce goods and services used by the company.
Antitrust policy generally precludes the elimination of competition. For this reason, mergers are often with companies in allied but not directly related fields.
20-2.
20-3.
20-4.
Chapter 20 - External Growth through Mergers
20-5.
20-6.
20-7.
20-8.
What is synergy? What might cause this result? Is there a tendency for
management to over- or underestimate the potential synergistic benefits of a merger?
Synergy is said to occur when the whole is greater than the sum of the parts. This “2 + 2 = 5” effect may be the result of eliminating overlapping functions in production and marketing as well as meshing together various engineering
capabilities. In terms of planning related to mergers, there is often a tendency to overestimate the possible synergistic benefits that might accrue.
If a firm wishes to achieve immediate appreciation in earnings per share as a result of a merger, how can this be best accomplished in terms of exchange variables? What is a possible drawback to this approach in terms of long-range considerations?
The firm can achieve this by acquiring a company at a lower P/E ratio than its own. The firm with a lower P/E ratio may also have a lower growth rate. It is possible that the combined growth rate for the surviving firm may be reduced and long-term earnings growth diminished.
It is possible for the postmerger P/E ratio to move in a direction opposite to that of the immediate postmerger earnings per share. Explain why this could happen.
If earnings per share show an immediate appreciation, the acquiring firm may be buying a slower growth firm as reflected in relative P/E ratios. This
immediate appreciation in earnings per share could be associated with a lower P/E ratio. The opposite effect could take place when there is an immediate dilution to earning per share. Obviously, a number of other factors will also come into play.
How is goodwill now treated in a merger?
It is placed on the books of the acquiring company, but it is not amortized. It is only written down if it is impaired.
Chapter 20 - External Growth through Mergers
20-9.
20-10.
Suggest some ways in which firms have tried to avoid being part of a target takeover.
An unfriendly takeover may be avoided by:
a. Turning to a second possible acquiring company—a “White Knight.” b. Moving corporate offices to states with tough pre-notification and protection provisions.
c. Buying back outstanding corporate stock. d. Encouraging employees to buy stock. e. Staggering the election of directors.
f. Increasing dividends to keep stockholders happy.
g. Buying up other companies to increase size and reduce vulnerability. h. Reducing the cash position to avoid a leveraged takeover.
What is a typical merger premium paid in a merger or acquisition? What effect does this premium have on the market value of the merger candidate and when is most of this movement likely to take place?
Typically, a merger premium of 40–60 percent is paid over the premerger price of the acquired company. The effect of the premium is to increase the price of the merger candidate, and most of this movement is likely to take place before public announcement.
Why do management and stockholders often have divergent viewpoints about the desirability of a takeover?
While management may wish to maintain their autonomy and perhaps keep their jobs, stockholders may wish to get the highest price possible for their holdings.
What is the purpose(s) of the two-step buyout from the viewpoint of the acquiring company?
The two-step buy-out provides a strong inducement to target stockholders to quickly react to the acquiring company’s initial offer. Also, it often allows the acquiring company to pay a lower total price than if a single offer is made.
20-11.
20-12.
Chapter 20 - External Growth through Mergers
Chapter 20 Problems
1.
Tax loss carryforward (LO20-1) The Clark Corporation desires to expand. It is
considering a cash purchase of Kent Enterprises for $3 million. Kent has a $700,000 tax loss carryforward that could be used immediately by the Clark Corporation, which is paying taxes at the rate of 30 percent. Kent will provide $420,000 per year in cash flow (aftertax income plus depreciation) for the next 20 years. If the Clark Corporation has a cost of capital of 13 percent, should the merger be undertaken?
20-1. Solution:
The Clark Corporation
Cash outflow: Purchase price $ 3,000,000 Less tax shield benefit from tax Loss carryforward ($700,000 × 30%) – 210,000 Net cash outflow $ 2,790,000
Cash inflows:
$420,000, n = 20, i = 13% (Appendix D) $420,000 × 7.025 = $ 2,950,500
Cash inflows $ 2,950,500 Cash outflow –2,790,000 Net present value $ 160,500
The positive net present value indicates the merger should be undertaken.
2.
Tax loss carryforward (LO20-1) Assume that Western Exploration Corp. is considering the acquisition of Ogden Drilling Company. The latter has a $470,000 tax loss carryforward. Projected earnings for the Western Exploration Corp. are as follows:
20X1
Before-tax income ................. $185,000
20X2 $250,000
20X3 $370,000
Total Values $805,000
Chapter 20 - External Growth through Mergers
Taxes (35%) .......................... 64,750 Income available
to stockholders ................... $120,250
87,500 $162,500
129,500 $240,500
281,750 $523,250
a. How much will the total taxes of Western Exploration Corp. be reduced as a result of the tax loss carryforward?
b. How much will the total income available to stockholders be for the three years if the acquisition occurs? Use the same format as that in the text.
20-2 Solution:
Western Exploration Corp.
a. Reduction in taxes due to tax loss carryforward = Loss × Tax rate
$470,000 × 35% = $164,500
b. Western Exploration Corp.(with merger and associated tax benefits)
Before tax income Tax loss carryforward
Net taxable income Taxes (40%) Aftertax income available to stockholders
* Before-tax income – Taxes ($370,000 – $117,250 = $252,750) ** Before-tax income – Taxes ($805,000 – $117,250 = $687,750)
20X1 20X2 $185,000 $250,000 185,000 250,000 0 0
0 0 20X3 Total $370,000 $805,000 35,000 470,000 335,000 335,000 117,250 117,250 $185,000 $250,000 $252,750* $687,750**
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