17.1 Mergers and Acquisitions

OBJECTIVE

To show how to use finance theory to analyze strategic decisions,such as acquiring or merging with another firm,spinning off a business unit as a separate firm,and investing in real options.

CONTENTS

17.1 Mergers and Acquisitions

17.2 spin-offs

17.3 Investing in Real Options

This chapter shows how to app1y finance theory to strategic decision making in firms.In chapter1we concluded that bothin theory and in practice the criterion for the managers of a firm in evaluating strategic decisions should be the maximization of the wealth of the company's owners.In chapters 6and 16,we showed how to apply discounted cash now analysis to estimate an investment's contribution to the wealth of a firm's owners.In this chapter we extend that analysis in two ways to examine two basic aspects of corporate strategy. First,we analyze corporate decisions regarding mergers,acquisitions,and spinoffs. Then we show how option theory can be applied to evaluate management's ability to time the start of an investment project,to expand it,or to abandon it after it has begun.

17.1 MERGERS AND ACQUISITIONS

When one firm acquires a controlling interest in another it is called an acquisition; when two firms join to form a new firm,it is called a merger. Under the criterion for good management of maximizing current shareholder’s,wealth,there are essentia1ly three reasons for considering acquiring or merging with another company: synergy,taxes,or bargains.Let us consider each.

Synergy is said to exist if:by combining two companies,the value of the operating assets of the combined firm will exceed the sum of the values of the operating assets of the two companies taken separately.Such synergy will occur if there are economies of scale in the production or distribution of the products of two or more firms.It can also occur through the elimination of duplicate efforts in management, intechnology,or in research and development.In essence,the value goes up because the factors of production are more efficiently organized in the combined firm.

For example,in 1995in the United States there was a wave of mergers among banks. The mergers were largely explained by the executives involved and by outside analysts as attempts to realize cost savings through consolidation of various banking activities and elimination of expensive duplicative technology. This interpretation was corroborated by the postmerger closing of many branch offices and the elimination of many jobs in the merged banks.

Another potential source ofincreased value to shareholders from mergers and acquisitions is a reduction in the taxes paid to the government by the companies involved in the merger.Even in the absence of opportunities to reduce production and distribution costs through true operating synergies,corporations can sometimes reduce the combined present values of their tax payments through a merger. For example,under certain conditions,a profitable firm may acquire an unprofitable firm and thereby reduce its taxes by exploiting the unprofitable firm's tax-loss carryforwards.

Unlike mergers motivated by synergies,solely tax-motivated business reorganizations add no net value to society at large. The market value of a firm reflects its value to the private sector. Because the firm pays taxes(or may pay taxes in the future),there is an additional value of the firm to society in the form of the present value of its tax payments. The sum of the market value in the private sector and this “shadow”value is the total value of the firm to society.

In the case of synergy, the value of the firm to society is increased with a corresponding increase in both the market and shadow social values of the firm.However,where a reduction in taxes is the sole reason for a merger,the value of the combined firm to society is just equal to the sum of the values to society of the r firms. This combination does not increase the total value to society,but it does redistribute the total between the shareholders of the firms and the tax-paying public.

A third reason for mergers and acquisitions is to take advantage of bargains in the stock market. If the firm to be acquired has a market value that is less than its intrinsic value, then by acquiring the firm, the management of the acquiring firm can increase its stockholders’ wealth.

There are two distinct reasons why a firm could be selling for less than intrinsic value. The first is that relative to the acquiring firm’s information set, the stock market is not efficient in the sense discussed in chapter 7. That is, the management of the acquiring firm believes that it has information such that if this information were widely known, the market value of the firm to be acquired would be higher than its acquisition cost. If this is the principal reason for the acquisition, then the management’s behavior is identical to that of a security analyst whose job it is to identify mispriced securities.

A second reason why a firm could be selling for less than its intrinsic value is that the firm to be acquired is currently being mismanaged. That is, through either incompetence or malevolence, the current management is not managing the firm’s resources so as to maximize the market value of the firm.Unlike the first reason, this reason is completely consistent with an efficient capital market.

Notable by its absence among the three valid reasons for acquisitions is diversification-the acquisition of another firm for the sole purpose of reducing the volatility (variance)ofthe firm's operations-Although diversification is a frequently cited reason for an acquisition,it is often not the real reason.More often than not, it will be for one of the three reasons already given.

However,if diversification is the real reason,then the acquisition route will in generalbe aninefficientwayto achieve it. Finance theoryand alarge amountof empirical evidence lead to the following conclusion:

The combined market value d two firms that merge solely in order to achieve diversification of risks is no more than the sum of the market values of the two separate firms.

In other words,in the area of corporate diversification the whole is worth no more than the sum of its parts.

The argument in favor of corporate diversification is often presented by analogy with an individual investor where we have seen in chapter 12that diversification is quite important.However,this type of argument simply illustrates the pitfalls of treating the firm as ifit were an individual household with its own preferences rather than as an economic organization designed to serve specific economic functions.

An intuitive explanation of why the market values of two firms will not be in- creased through a merger even though the combined firm may have a smaller total risk (variance)than the individual firms is as follows:In order for investors to be willing to pay a higher price for the combined firm than they were willing to pay for the two firms separately,the act of combining the two firms mustprovideaservice to the investors that they were previously unable to obtain.

However,prior to the combination,investors could purchase shares of either or both firms in any mix they want.In particular,in the case of a merger,investors can purchase the shares of both firms in the same ratio implicit in the combined firm.Hence,investors could achieve for themselves (prior to the merger)the same amountofdiversification(oftherisks ofbothfirms)asisprovidedbythe combined firm. Therefore,the merger provides no new diversification opportunities to investors.For that reason,investors would not pay a premium for the combined firm. Indeed,in the absence of diversification benefits,the combined firm should sell for less than the sum of the values of the two separate firms simply because there are costs to doing the merger.

Firm diversification can also hurt market value by reducing the investment choices available to investors and by reducing the amount of information available to investors.After consolidation of the two firms,investors have fewer choices for portfolio constructionthan they did before consolidation.For example,prior to a merger,investors could hold any amounts of each of the two merging firms.After the merger,the only way that investors can hold firm 1is to invest in the combined firm,which means they must also invest in firm 2.Indeed,they can only invest infirm 1if they are willing to invest in firm 2in the relative proportions of the postmerger firm. The consolidated accounting and other public statements of the merged firm will typically contain less total information than was provided to investors in the individual filings when the companies were separate. Unless this increase in “opaqueness”permits the firm to improve its profitability,the reduction in information is likely to cause a reduction in firm value.

Note that this negative aspect of firm diversification applies even in a frictionless world of no transactions costs and where the merger takes place on term where no premium above market value is paid for the acquired firm by the acquiring firm.In the real world,the acquiring firm must usually pay a premium above the market value to acquire a firm. The premium can range from 5%to more than 100%with an average somewhere around 20%.A natural question to ask is: Why do the owners of the firm to be acquired demand a premium for their shares?

Although there are several possible explanations,one that is consistent with our previous analyses is as follows:If the acquiring firm's management is behaving optimally, then the reason for its making a takeover attempt must be one of the three reasons discussed at the outset ofthis section-Because any one of these three reasons will increase the value of the acquiring firm's shares,the acquired firm's shareholders are demanding compensation for providing the means for this increase in value.

How this potential increase in value is shared between the acquiring and acquired firms,shareholders cannot be determined in general (as is the usua1case for bilateral bargaining),but almost certainly,the acquired firm's shareholders will receive some positive share.Of course,the acquired firm's shareholders do not know what the acquiring firm's management believes the value of the acquired firm is. Hence,it might appear that no consolidation could be consummated because whatever price is offered, clearly,the acquiring firm's management believes it is worth more and,therefore,the acquired firm's shareholders should demand more.

However,the fact that the acquiring firm shareholders believe it is worth more does not mean that it is,indeed,worth more. Their beliefs may be wrong.Hence, at high enough price above market,the acquired firm's shareholders will take the sure premium,and let the acquiring firm take the risk (and earn the possible reward) that its information is sufficiently superior to the market’s that the acquired firm is still a “bargain”.

Whether or not the acquired firm’s shareholders or the acquiring firm’s shareholders come out ahead on these takeovers is still an open empirical question. However, it is clear that acquiring another firm for the sole purpose of diversification is a losing proposition for the acquiring firm because it must pay a premium for a firm whose acquisition promises no increase in market value even if it is purchased without paying a premium over the market price prior to the announcement of the takeover.

Although the premium paid over market value for the acquired firm is usually the principal cost of an acquisition, there are other costs as well that can frequently be substantial. In an uncontested merger, there are legal costs and management’s time that could be spent on other activities. There are uncertainties created for the acquired firm’s management, employee, supplies, and customers that could affect the operations of that firm during the negotiations and subsequent transition. Of course, if the merger is contested, then litigation costs will be substantial.

Even if it is decided that firm diversification is warranted, then achieving this diversification through acquisition is very costly. If it is costly for your shareholders to diversify their portfolios by direct purchase of individual firms’ shares, then this service almost surely can be provided at less cost by mutual funds, investment companies, and other financial intermediaries. If, because of management risk aversion or debt capacity or supplier concerns,it is decided that the volatility or total risk of the firmshouldbe reduced,thenthis can be achievedmuchmore efficiently (i.e.,at lowercost)bysimplypurchasing aportfolio ofequities andfixed-incomesecurities in which no premium is paid over market and no significant transactions costs are incurred.In general,the risk management objectives of a firm can be implemented more efficiently by using a growing array of financial technologies and specialized products provided by financial-service firms.

If diversification is desired simply to provide cash now from these operations to fund growth investments in current operations,then it is almost certainly less costly to issue securities and raise the funds in the capital markets.Don't pay $12to $20to acquire $10in cash!

In summary,there are three types of reasons for a firm to consider the acquisition of another firm:

1.synergy

2.taxes

3.the firm to be acquired is a bargain

They all have in common that the acquisition should increase the value of theacquiring firm's current stockholders'wealth.

The possibility of a takeover ofone firm by another is an important check that servesto force managements ofpubliclyowned firms topursue policiesthat are (at least approximately)value maximizing.

Simple diversificationby the firm is, ingeneral,notan important objective for the management of the firm.Hence,ifpursued,then a minimum ofresources should be used to achieve it.Specifically,the acquisition of another firm is a costly way to achieve diversification.

Beware:Diversification is frequently given as the reason for acquiring a firm by the acquiring firm's management.Ifcarefully investigated (most ofthe time),the meaning of diversification as used is not the one described here,and the real reasons will be one or more of the three (proper)reasons for making an acquisition.

17.2 SPIN-OFFS

Aspin-off occurs when a corporation divests itself of one or more of its business units and creates a separate company with assets,liabilities,and stock ofits own.For example,in 1997Pepsico spun off its restaurant division,giving it$1billion (at book value)in assets and $12billion (at book value)in liabilities. What reasons might there be for a corporation to spin off a business unit?

From the perspective of value maximization it pays to spin off a business unit if the sum of the expected market values of the separate businesses-often called the firm's“breakup”value-exceeds the firm's value as a single entity. The reasoningis identical to the reasoning behind a merger or acquisition discussed in section 17.1. If there is no synergy between the business units comprising a multidivisional firm, then the business units are more valuable as separate firms.

There is another possible reason for a multidivisional firm to spin off business units into separate firms,even if the sum of the value of the assets after the breakup does not exceed the value of the firm as a single entity.If the firm has a lot of long term,fixed-income liabilities,then it may be possible for management to increase the wealth of shareholders at the expense of the firm's creditors by breaking the firm up into two or more separate firms.

To see how this is possible,let us consider Multicorp,a firm with two divisions, each of which has assets worth $1billion.Assume that the returns on each of the separate divisions are quite risky,but that they are perfectly negatively correlated, so that in combination Multicorp has a riskless return. The riskless rate of interest is5%per year,and that is also the expected equilibrium rate of return on each d the two divisions.Assume that Multicorp has $1billion of long-term debt,which also bears an interest rate of 5%per year.

Before the spin-off,the market value of the debt is$1billion because there is no uncertainty about the firm's earning a risk-free 5%rate ofreturn. However,sup pose that Multicorp spins off one of its divisions as a new firm,Unicorp,with$1billion in assets and $0.5billion ofMulticorp's debt. The combined market value ofthe two separate firms is still$2billion,but the debt will fall in market value because there is now a possibility of default for each of the separate firms. The decline in the value of the debt accrues to the shareholders of Multicorp,who are now the shareholders of both Multicorp and Unicorp.

Note that the transfer of wealth from Multicorp's creditors to its shareholder is only with respect to the existing debt. After the spill-off,lenders would require an interest-rate premium that is large enough to compensate them for the risk ofdefault.

17.3 INVESTING IN REAL OPTIONS

To this pointwe have ignored an extremely important aspect ofmany(ifnotmost) corporate investment opportunities-the ability of managers to delay the start of project,or once started,to expand it or to abandon it.Failure to take account of these real options (as contrasted with financial options)will cause an analyst evaluating the project to underestimate its NPV.