Mergers - Financial Management

Businesses grow externally by acquiring, or combining with, other ongoing businesses; this is in contrast to internal growth, which is achieved by purchasing individual assets, such as those evaluated in the discussion of capital expenditures. When two companies combine, the acquiring company generally pays for the acquired business either with cash or with its own securities, and the acquired company’s liabilities and assets are transferred to the acquiring company.

Mergers Defined

A merger is technically a combination of two or more companies in which all but one of the combining companies legally cease to exist and the surviving company continues in operation under its original name. A consolidation is a combination in which all of the combining companies are dissolved and a new firm is formed. The term merger is generally used to describe both of these types of business combinations. Acquisition is also used interchangeably with merger to describe a business combination. In the following discussion, the term merger is used, and it is assumed that only two companies are involved—the acquiring company and the merger candidate.

Merger Statistics

Merger activity ebbs and flows with the state of the economy. Merger activity expanded greatly during the late 1980s, reaching a high in 1989. In that year, there were more than 3,800 merger transactions valued at $5 million or more involving U.S. corporations, with the aggregate value of these transactions being over $311 billion.2 During the recession of the early 1990s, the aggregate value of mergers declined to a low of $123 billion in 1992. Beginning in 1993 during a period of relative prosperity, the aggregate value of mergers increased each year for the next 7 years, reaching a peak of $1.78 trillion in 2000. During the subsequent downturn in the economy beginning in 2001, merger activity dropped to slightly over $500 billion in 2003.4 on page 768 contains a listing of the largest mergers involving U.S. companies. Many transactions are international in scope—that is, they involve both U.S. and foreign companies.

Some of the acquisitions involve the purchase of U.S. companies by foreign companies, such as British Petroleum’s purchase of Amoco and Daimler-Benz’s purchase of Chrysler. Not all mergers that are announced end up being completed. For example, MCI WorldCom’s proposed acquisition of Sprint for $114 billion failed because of government regulatory issues. American Home Products was unsuccessful in its attempt to acquire Warner-Lambert when it was outbid by Pfizer.

Types of Mergers

Mergers are generally classified according to whether they are horizontal, vertical, or conglomerate. A horizontal merger is a combination of two or more companies that compete directly with one another: for example, the acquisition of Amoco by British Petroleum— both large integrated companies —was a horizontal merger. The U.S. government has vigorously enforced antitrust legislation in an attempt to stop large horizontal combinations, and this effort has been effective. However, horizontal combinations in which one of the firms is failing are often viewed more favorably. Also, mergers that allow the companies to compete effectively in world markets are viewed more favorably —the acquisition of McDonnell Douglas by Boeing was an example of this type of horizontal merger.

A vertical merger is a combination of companies that may have a buyer-seller relationship with one another. For example, if Sears were to acquire one of its appliance suppliers, this would constitute a vertical merger. This type of business combination has gradually declined in importance in recent years.

A conglomerate merger is a combination of two or more companies in which neither competes directly with the other and no buyer-seller relationship exists. For example, the Philip Morris (now Atria Group) acquisition of General Foods in 1985 was a conglomerate merger.

Form of Merger Transactions

A merger transaction may be a stock purchase or an asset purchase. In a stock purchase, the acquiring company buys the stock of the to -be -acquired company and assumes its liabilities. In an asset purchase, the acquiring company buys only the assets (some or all) of the to-be-acquired company and does not assume any of its liabilities.

Large-Mergers-and-Acquisitions-Involving-U_S Companies

Large Mergers and Acquisitions Involving U.S. Companies*

Normally, the buyer of a business prefers an asset purchase rather than a stock purchase, because unknown liabilities, such as any future lawsuits against the company, are not incurred. In addition, an asset purchase frequently allows the acquiring company to depreciate its new assets from a higher basis than is possible in a stock purchase. As a result of the unknown liability question, many large companies that acquire small companies refuse to negotiate on any terms other than an asset purchase.

Holding Companies

One form of business combination is the holding company, in which the acquiring company simply purchases all or a controlling block of another company’s common shares. The two companies then become affiliated, and the acquiring company becomes the holding company in this parent-subsidiary relationship.Many large banks are organized as holding companies with subsidiaries offering various types of financial products and services. For example, Mellon Financial Corporation has a number of subsidiaries, including The Dreyfus Company (mutual funds), and The Boston Company (trust and money management).

Joint Ventures

Another form of business combination is a joint venture, in which two (unaffiliated) companies contribute financial and/or physical assets, as well as personnel, to a new company formed to engage in some economic activity, such as the production or marketing of a product. The Dow Corning Company is an example of a joint venture established by Dow Chemical and Corning in 1943. Dow Chemical and Corning each have a 50 percent interest in the company. Joint ventures are often international in scope, such as the agreement among IBM (United States), Toshiba (Japan), and Siemens (Germany) to form a company to develop and produce computer memory chips.

Leveraged Buyouts

One frequently used method to buy a company or a division of a large company is a leveraged buyout, or LBO. In a typical LBO, the buyer borrows a large amount of the purchase price, using the purchased assets as collateral for a large portion of the borrowings. The buyers are frequently the managers of the division or company being sold. It is anticipated that the earnings (and cash flows) of the new company will be sufficient to service the debt and permit the new owners to earn a reasonable return on their investment. In some cases, sales of assets are used to help pay off the debt. The LBO of a publicly held company is sometimes referred to as going private because the entire equity in the company is purchased by a small group of investors and is no longer publicly traded.

The majority of LBOs involve relatively small companies. However, a number of LBOs involving large companies have occurred. For example, in the largest merger or acquisition ever undertaken up to that time, the investment firm of Kohlberg Kravis Roberts used an LBO to purchase RJR Nabisco for $24.7 billion in 1989. However, by the early 1990s, the number of LBO transactions had declined sharply, partly because many existing LBOs were experiencing difficulties servicing their large debt loads.

In addition to LBOs undertaken by investment bankers and managers, workers sometimes take over their division or company through an Employee Stock Ownership Plan (ESOP). Significant tax advantages make ESOPs a useful instrument for financing LBOs. In an ESOP transaction, lenders can offer below-market interest rates because 50 percent of the interest income they receive from these loans is excluded from taxable income; this often allows employees to pay more than other bidders that do not qualify for these tax breaks. In the past, ESOPs were used to buy either larger companies faced with financial difficulties or smaller companies.However, ESOPs have also been used to finance (either in whole or in part) large, healthy companies, such as JCPenney.

Divestitures and Restructurings

Divestitures and restructurings can be an important part of a company’s merger and acquisition strategy. After an acquiring company completes an acquisition, it frequently examines the various assets and divisions of the recently acquired company to determine whether all the acquired company’s pieces “fit” into the acquiring company’s future plans. If not, the acquiring company may sell off, or divest, a portion of the acquired company. In so doing, the acquiring company is said to be restructuring itself.

Divestitures and restructurings, however, are frequently not associated directly with a company’s acquisitions. A company may divest itself of certain assets because of a change in overall corporate strategy. For example, Warner-Lambert, a drug and consumer products manufacturer, decided to get out of the hospital supply business. The company used the proceeds from the sale of its hospital supply assets to buy back some of its stock. As a result,Warner -Lambert changed, or restructured, the asset side of its balance sheet; this is called an operational restructuring. In addition, the company changed its capital structure and thereby carried out a financial restructuring.

Instead of selling a part of the company for cash, divestitures can be accomplished through a spin -off or an equity carve-out. In a spin-off, common stock in a division or subsidiary is distributed to shareholders of the parent company on a pro rata basis. The subsidiary or division becomes a separate company. Owners of the parent company who receive common stock in the new company can keep the shares or sell them to other investors. An example of such a divestiture was the 1996 breakup of AT&T, where AT&T shareholders received stock in two additional new companies—Lucent Technologies (network equipment) and NCR (global information systems). In an equity carve -out, or partial public offering, common stock in the subsidiary or division is sold directly to the public, with the parent company usually retaining a controlling interest in the shares outstanding. For example, in 1993 Sears sold a 20 percent stake in its Allstate insurance subsidiary through an initial public offering, while retaining an 80 percent interest in the unit. Two years later in 1995, Sears spun off the remaining 80 percent interest in Allstate through a special tax-free dividend to its common stockholders. Spin-offs and equity carve-outs can be used by large, diversified companies to remove either an underperforming unit (e.g., Anheuser -Busch’s Earthgrains bakery business) that is hurting the overall firm or a healthy subsidiary (e.g., Sears’ Allstate insurance unit) that is buried among underperforming units.

In the 1990s and later, spin-offs may achieve the same results that leveraged buyouts did in the 1980s, namely, more focused and efficient companies. An alternative to either selling or spinning off a division is to issue a tracking stock. A tracking stock enables a large company that has a subsidiary in a high-growth business, which is buried within the organization, to capture the value of this business. The theory is that the sum of the values of the tracking stock of the high-growth business and the parent company’s stock, which are traded separately, will be worth more than the single stock of the parent company.

Tracking stocks were first issued in the mid-1980s when General Motors created separate stocks for two of its higher growth subsidiaries—namely, Electronic Data Services and Hughes Electronics. Other companies, such as AT&T and Circuit City, also issued tracking stocks for their faster growing subsidiaries, namely, Liberty Media and Car Max, respectively. During the boom for Internet stocks in the late 1990s, a number of companies with online subsidiaries, such as Donaldson, Lufkin & Jenrette (securities broker), issued tracking stocks.

Tender Offers

Although many mergers are the result of a friendly agreement between the two companies, a company may wish to acquire another company even when the combination is opposed by the management or board of directors of the merger candidate company. In such a case, the acquiring company makes a tender offer for common shares of the merger candidate. In a tender offer, the acquiring company effectively announces that it will pay a certain price above the then-existing market price for any of the merger candidate’s shares that are “tendered” (that is, offered to it) before a particular date.

Rationale for Restructuring

A number of reasons have been suggested for the increased corporate restructuring activity during the 1980s and 1990s. According to Jensen, the most important reason was the failure of internal control mechanisms to prevent unproductive capital investment (that is, overinvestment) and organizational inefficiencies (overstaffing) by many large U.S. corporations. He claims that this control system—the internal management supervised by a board of directors—breaks down in mature companies with large cash flows and few good investment opportunities. Firms in the oil, tobacco, food processing, and retailing industries have been notable in this regard. These inefficiencies allow acquirers to pay a large premium over the pretakeover market value of the company and earn high returns on their investment by using the acquired company’s resources more efficiently.

A second reason cited is the emergence of investors, such as Kohlberg Kravis Roberts & Company,Warren Buffett, and the Bass brothers, who hold large equity (and/or debt) positions in the companies. Unlike more passive institutional investors, such as pension funds, these investors take an active role in setting the strategic direction and monitoring the performance of the companies. Often these investors give managers significant equity positions in the companies as incentives to operate efficiently and increase shareholder value. Also, in the case of highly leveraged transactions, such as LBOs, large debt service payments put pressure on managers to reduce costs and make better capital investment decisions. A third reason for the corporate restructuring boom of the 1980s was the ready availability of credit to finance these transactions. Junk bond financing, underwritten by Drexel Burnham Lambert and other investment banks, as well as financing provided by commercial banks, insurance companies, and pension funds, provided debt capital that permitted acquirers to leverage their purchases.

Finally, the inflationary environment and long economic expansion of the 1980s increased the revenues and asset values of the acquired companies. This allowed acquirers to sell off unwanted corporate assets and to meet their debt obligations.

Antitakeover Measures

In response to the merger and acquisitions boom of the late 1980s, many companies adopted various measures designed to discourage unfriendly takeover attempts. These antitakeover measures, sometimes referred to as shark repellants, include

  1. Staggered board. Stagger the terms of the board of directors over several years instead of having the entire board come up for election at one time. Thus, the acquiring firm will have difficulty electing its own board of directors to gain control.
  2. Golden parachute contracts. Give key executives employment contracts under which the executives will receive large benefits if they are terminated without sufficient cause after a merger. Corporate takeovers often raise serious agency problems between stockholders and managers. A takeover at a large premium over the current market price of the firm’s stock is beneficial to stockholders. At the same time, the offer may be detrimental to managers because they may lose their jobs if the takeover is successful and the new owners replace them. Golden parachute contracts are used to encourage management to act in the interests of stockholders in any takeover attempt.
  3. Supermajority voting rules. Insert in the corporate charter voting rules that require a supermajority of shares (e.g., 80 percent) to approve any takeover proposals.
  4. Use poison puts. Issue securities that become valuable only when an unfriendly bidder obtains control of a certain percentage of a company’s shares. One example is a bond that contains a put option (called a “poison put”) that can be exercised only if an unfriendly takeover occurs. The issuing company hopes that the cashing in by bondholders of a portion of its debt will make the takeover unattractive.

Once an unfriendly takeover attempt has been initiated, the target company’s management has various other antitakeover measures that it can employ to deter a takeover, including

  1. White knight. The target company’s management can try to find another, more friendly acquiring company that is willing to enter into a bidding war with the company making the first offer.
  2. Standstill agreement. The target company’s management can attempt to negotiate an agreement with the bidder whereby the bidder agrees to limit its holdings in the target company.
  3. Pacman defense. Named after the video game, the target company can make a takeover bid for the stock of the bidder.
  4. Litigation. Legal action (i.e., suits and appeals in state and federal courts) can be used to delay a takeover attempt.
  5. Asset and/or liability restructuring. A target company can sell assets that the bidder wants to another company, or it can issue larger amounts of debt and use the proceeds to repurchase its common stock. These actions make the target company less desirable to the bidder.
  6. Greenmail. The takeover candidate can attempt to buy back its shares, at a premium over the shares’ market price, from the company or investor who initiated the unfriendly takeover attempt. The amount of the premium is referred to as “greenmail.”

More recently, institutional investors, who often control a significant block of a company’s stock, have become increasingly active participants in battles for control in many firms. For example, the college teachers’ retirement fund, TIAA-CREF, got seven companies to revoke various antitakover measures. Some institutional investors have used what is called boardmail to fight antitakeover devices, such as poison pills and staggered elections of board members. Boardmail consists of requiring the board of directors to adopt weaker antitakeover measures in exchange for voting support from the institutional owners. In some cases, institutions have been successful in placing sympathetic members on boards of companies in which the institution has a significant ownership interest.

Reasons for Mergers

The following are some of the reasons why a firm might consider acquiring another firm, rather than choosing to grow internally:

  • A firm may be able to acquire certain desirable assets at a lower cost by combining with another firm than it could if it purchased the assets directly. In this context, when the market value of a company’s common stock is below its book value (or, more important, below the replacement value of the firm’s net assets), this company is frequently considered a possible “takeover candidate.”
  • A firm may be able to achieve greater economies of scale by merging with another firm; this is particularly true in the case of a horizontal merger.When the net income for the combined companies after merger exceeds the sum of the net incomes prior to the merger, synergy is said to exist. For example, in the merger proposed between Manufacturers Hanover and Chemical Bank, the banks expected to be able to reduce their combined workforce by about 6,200 employees and eliminate other duplicated costs, resulting in savings of up to $650 million per year.
  • A firm that is concerned about its sources of raw materials or end-product markets might acquire other firms at different stages of its production or distribution processes. These are vertical mergers. For example, in 1984 Mobil Corporation (now part of ExxonMobil), a major international oil company considered strong in refining and marketing but somewhat “crude poor,” acquired Superior Oil Company, which owned large oil and gas reserves and had no refining and marketing operations. The acquisition resulted in Mobil becoming a better-balanced oil company.
  • A firm may wish to grow more rapidly than is possible through internal expansion. Acquiring another company may allow a growing firm to move more rapidly into a geographic or product area in which the acquired firm already has established markets, sales personnel, management capability, warehouse facilities, and so on, than would be possible by starting from scratch.
  • A firm may desire to diversify its product lines and businesses in an attempt to reduce its business risk by smoothing out cyclical movements in its earnings. For example, a capital equipment manufacturer might achieve steadier earnings by expanding into the replacement parts business. During a recession, expenditures for capital equipment may slow down, but expenditures on maintenance and replacement parts may increase. This reason is of questionable benefit to the company’s shareholders because most investors can diversify their holdings (through the securities markets) more easily and at a lower cost than the company can.
  • A firm that has suffered losses and has a tax-loss carryforward may be a valuable merger candidate to a company that is generating taxable income. If the two companies merge, the losses may be deductible from the profitable company’s taxable income and hence lower the combined company’s income tax payments. This was a major factor in NCNB’s acquisition of the failed First Republic Bank in Texas.

This list, although not exhaustive, does indicate the principal reasons why a firm may choose external expansion over internal growth. If one firm wishes to acquire all or a portion of another firm, it is important to question whether the acquisition will be anything more than a zero net present value project in an efficient capital market. If it is, this excess value must result from the acquiring firm’s access to superior managerial and labor talents at costs not fully reflective of their marginal value, access to raw material and other necessary inputs at lower costs, an ability to price the product in a more profitable way (perhaps because of an established brand name), operating synergies in the production and/or distribution areas, access to capital at a lower cost, generally more efficient operations due to lower agency costs in the acquiring firm compared to those in the acquired firm, or some other reason. Each of these possible reasons is suggestive of an inefficiency in a factor, product, or portion of the capital markets.

A number of empirical studies have examined the returns to the stockholders of the merger candidate and the acquiring company in a takeover.7 Because the acquiring company must pay a premium over the current market price to obtain the merger candidate, one would expect to see positive returns to the acquired firm’s shareholders. This is the case, with average returns of 20 percent or more in successful mergers.8 For the acquiring company’s shareholders, the returns are not as good—averaging 5 percent or less in successful mergers.

Accounting Aspects of Mergers

Two basic methods can be used to account for mergers: the purchase method or the pooling of interests method. In the purchase method, the total value paid or exchanged for the acquired firm’s assets is recorded on the acquiring company’s books. The tangible assets acquired are recorded at their fair market values, which may or may not be more than the amount at which they were carried on the acquired firm’s balance sheet prior to the merger. The excess of the total value paid over the fair market value of the acquired assets is an intangible asset termed goodwill. The intangible asset of goodwill can be quite significant for many companies. For example, when Philip Morris purchased Kraft, Inc., in 1988 for $12.9 billion, the fair market value of Kraft’s physical assets was about $1.3 billion—the difference of $11.6 billion, or 90 percent of the purchase price, represented the intangible asset of goodwill (i.e., Kraft brands and consumer loyalty).

In the pooling of interests method, the acquired company’s assets are recorded on the acquiring company’s books at their cost (net of depreciation) when originally acquired. Thus, any difference between the purchase price and the book value is not recorded on the acquiring company’s books, and no goodwill account is created.

The pooling of interests method has certain advantages over the purchase method. All other things being equal, reported earnings will be higher under the pooling method, primarily because depreciation will not be more than the sum of the depreciation charges prior to the merger. In addition, because goodwill is not created on the balance sheet in a pooling, it cannot appear as an amortization charge on the acquiring firm’s income statement. For example, suppose that Company B acquires Company A’s outstanding common stock for $10 million. The book value of the acquired shares is $7 million. shows the results of this merger, according to both the purchase and pooling of interests methods.

Comparison-of-the-Purchase-and-the-Pooling-of-Interests-Methods-of Accounting for mergers

In the pooling of interests method, the two balance sheets are combined, and the $3 million difference between the purchase price and the book value of Company A’s stock is not considered. In the purchase method, in contrast, the $3 million difference between the purchase price and the book value is recorded on both sides of Company B’s postmerger balance sheet as an increase in total assets and as stockholders’ equity.

Comparison of the Purchase and the Pooling of Interests Methods of

The book value of Company A’s assets is $10 million. Suppose that the market value of Company A’s assets at the date of acquisition is $11 million. Company B paid $3 million above the book value of stockholders’ equity. Of this $3 million, the $1 million difference between the assets’ market value and book value is recorded on the balance sheet in the appropriate tangible assets accounts. The other $2 million is recorded as goodwill. Nine of the 10 largest mergers of 1998, including the Daimler-Benz purchase of Chrysler, used the pooling of interests method of valuation. Despite its popularity, the Financial Accounting Standards Board voted to eliminate the pooling of interests method for mergers occurring after January 1, 2000. The objective of this change is to create more compatible financial statements among companies that make acquisitions. Also, this decision is more consistent with international accounting standards, which generally do not allow the pooling of interests method.

Tax Aspects of Mergers

Taxes can play an important role in determining how an acquired company’s shareholders receive compensation for their shares.Merger transactions that are effected through the use of voting equity securities (either common stock or voting preferred stock) are tax-free. For example, if an acquired company’s stockholders have a gain on the value of their shares at the time of the merger, the gain is not recognized for tax purposes if these shareholders receive voting equity securities of the acquiring company; any gains are not recognized until the newly acquired shares are sold.

In contrast, if the acquired company’s shareholders receive cash or nonvoting securities (such as debt securities, nonvoting preferred stock, or warrants) in exchange for their shares, any gains are taxable at the time of the merger.When a partial cash down payment is made, however, the exchange can be treated as an installment purchase, and the seller can spread the tax liability that is created over the payment period.


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