3.3 Establishing the Economic Rationale for Takeover Activity

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Corporate Financial Decision-Making for Value Creation

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The University of Melbourne

Corporate Financial Decision-Making for Value Creation

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Cours 3 sur 5 dans Specialization Essentials of Corporate Finance

In this course, participants will learn about the key financial decisions modern corporations face, as well as the alternative methods that can be employed to optimize the value of the firm’s assets. This is part of a Specialization in corporate finance created in partnership between the University of Melbourne and Bank of New York Mellon (BNY Mellon).

À partir de la leçon

Creating Value via Takeovers, Mergers and Corporate Restructuring

During week 3 we will explain how takeovers and mergers occur in practice, define the key terms used in the analysis of markets for corporate control and then develop an understanding of how changes in control might be objectively assessed via financial analysis. In addition to answering the question “how might we create wealth through growth?” we will also consider how value might be created by getting smaller in our review of the impact of corporate restructuring on shareholder wealth.

3.0 Welcome and Introduction6:34

3.1 The Anatomy of an Acquisition7:22

3.2 The Financial Evaluation of a Takeover12:51

3.3 Establishing the Economic Rationale for Takeover Activity12:25

3.4 Corporate Restructuring via Spinoffs, Divestitures and Equity Carve-outs8:39

3.5 Empirical Evidence of the Wealth Impact of Mergers, Acquisitions and Corporate Restructuring10:09

Rencontrer les enseignants

Paul Kofman
Dean, Faculty of Business and Economics
Sidney Myer Chair of Commerce
Sean Pinder
Associate Professor
Faculty of Business and Economics

So far we've built our dictionary of M&A terms, identified alternative methods of

payment, and established an economic framework for evaluating the wealth effect

from merger activity, for both target and bidder shareholders.

Now we're going to switch tacks slightly and

critically assess the different justifications

commonly put forward by management teams proposing M&A transactions.

Now let's pause for a moment and recall that for

a merger to be economically justifiable from a bidding shareholder's point of

view, we need the NPV of the deal to be positive.

That is, we need to ensure that we don't pay out all of the gains, and

perhaps more, to the target shareholders in the form of a control premium.

Why should bidding shareholders be so concerned?

Well, the reason is that bidding management may have an incentive for

a merger to proceed, even when the merger destroys value for bidder shareholders.

For example, executive compensation may reasonably be expected to be linked to

the size of an organization.

Giving management an obvious incentive to grow the firm,

despite potentially negative impacts on shareholder value.

The first valid reason for M&A activity is to take advantage of synergies

created by combining two business units into one.

Some common sources of synergies include the elimination of duplicate costs,

after all you only need CEO.

Alternatively, we might like to take advantage of economies of scale so

as to reduce our per unit cost.

Finally, we might be able to take advantage of revenue synergies,

which simply reflect an opportunity to increase revenues

by being able to sell one firm's product to another firm's customer base.

A note of caution, though.

It's very easy to claim the existence of synergies.

A diligent shareholder group will demand specifics in terms of where

they're expected to be created.

An example of an acquisition that was motivated by synergistic benefits occurred

in September 2009 when Kellogg's competitor, Kraft,

announced a 10.2 billion pound bid for UK confectionary firm, Cadbury.

In an official statement released to the market

Kraft identified significant revenue synergies

by being able to access Cadbury customers that they could market Kraft products to.

As well as a reduction in costs that was to be, at least partly,

achieved by removing processes that were duplicated across the firms.

The second potentially valid reason for

an acquisition relates to the removal of inefficient target management.

This justification is based on the idea that a new management team can deliver

greater value out of the target firm's assets than the existing management team.

So, in this setting, merger and

acquisition activity acts as a disciplinary measure

where we have management teams actively roving the markets looking for

inefficiently run firms from which value could be created with change in ownership.

A classic example would be where a management team was perceived to

be wasting money on the consumption of perquisites

such as the flash corporate jet.

And this value destruction could be immediately translated into a gain

from acquisition, if a change in management occurred and the jet was sold.

The third potentially valid reason for M&A activity, from an economic perspective,

is it can act to reduce competition and thereby increase a firm's market power

in negotiating prices with both its customers and its suppliers.

Now governments are awake to this of course.

And we see that most jurisdictions will have dedicated regulatory authorities

who will not hesitate to step in if competition is significantly compromised.

The fourth justification for

M&A activity relates to the ability to reduce taxes via a merger.

There are two channels by which this might take place.

Firstly, a target firm that has a lot of accumulated tax losses, which of

course are valuable, in that they can be deducted against future tax liabilities,

may not be able to actually use them for some years.

If a currently profitable bidder can make immediate use of those tax losses,

than the difference in the present values will reflect a gain from acquisition.

The second way in which firms create value via tax motivated mergers,

is where a firm is able to shift its residency from a high tax,

to a low tax jurisdiction, in a process we refer to as tax inversion.

A relatively recent example of just such an acquisition occurred when US

based Burger King acquired famous Canadian coffee and donuts company Tim Horton's,

and promptly shifted its tax residencey to the land of the maple leaf.

So there's at least four broad categories where M&A activity

could be economically justifiable from a bidding shareholder's point of view.

Now, let's consider some more dubious reasons for mergers and acquisitions.

The first relates to an increase in EPS that follows an acquisition.

Now, it's not so much that an increase in EPS is bad.

It's just that an increase in EPS does not necessarily

coincide with an increasing shareholder value.

To demonstrate this lets consider the following example relating to Bidder and

Target Limited.

Bidder is a company with a higher earnings per share, a higher P/E ratio,

implying perhaps higher growth opportunities, and

a significantly higher market capitalization than Target limited.

Let's also assume that for this merger there are no gains at all and

the terms of the deal is that for every five Target shares held,

Target shareholders will receive one share in Bidder Limited.

Now, let's demonstrate

how mistakes can be made in financial analysis with dealing with M&A activity.

What we have here is a table of metrics.

The first two columns relate to the Bidder and Target firms operating independently.

The third column reflects what we expect to see for

the merged entity, once the acquisition has been completed.

Now do you see the numbers in red to the right of the screen?

They indicate the order of calculation that we're going to follow.

To see what can go wrong.

So starting with number one.

We know that the merged firm will have earnings of $2,750,000,

which is simply sum of the earnings for the two firms independently.

Now to number two.

As we are issuing one share in Bidder Ltd for

every five shares held by Target shareholders in Target Ltd.

We know that in total we'll be issuing 30,000 additional shares,

bringing the total number of Bidder Ltd shares to 230,000.

Next is number three.

Where we simply divide the total earnings of the merged company,

$2,750,000, by the new number of shares on issue 230,000 shares,

giving us an earnings per share figure of $11.957 cents.

The fourth step is simple.

The P/E ratio of Bidder Limited is ten, and post merger the company is Bidder Ltd.

So we'll use a P/E ratio of ten.

Now to step five.

If you multiply EPS, earnings per share by the P/E ratio,

you end up with the price of the share.

So $11.957 multiplied by 10 equals a share price of $119.57.

Step six is to multiply the number of shares on issue by the share price

to obtain the market capitalization.

That is, the market value of equity of the entire firm.

And here we end up with a market capitalization of $27,500,000.

That's an increase of $4.5 million dollars

over and above the value of the two companies operating independently.

And that's in the absence of any synergies.

Obviously we did something wrong.

Could you see what it was?

Well, let's go back and re-consider the P/E ratio for the combined firm.

Firstly, let's recall what the P/E ratio for a firm reflects.

At its core, it's how much investors are willing to pay per dollar

of current earnings generated by the firm.

Now this number is going to be effected by both the risk of the earnings stream,

as well as the opportunities to grow those earnings in the future.

So in the previous slide, we assumed that the appropriate P/E ratio for

the combined entity was the P/E ratio of the bidding company.

Whereas in reality, the combined firm's P/E ratio will be an average of

the Bidder and Target companies P/E ratios, where the appropriate weights

of the contribution made to the combined firm's earnings by each company.

So, as you can see with this calculation, the combined firm's

P/E ratio is actually 8.3636, not 10.

Okay, let's substitute that back into our previous analysis.

The first three steps are identical to the previous example.

And then at step four, we insert a P/E ratio of 8.3636.

To calculate the share price we multiply that P/E ratio by

the earnings per share figure and we end up with a share price of $100 per share.

Multiply the share price by the number of shares on issue.

And we find that the market capitalization of the combined company is $23 million.

Which of course is simply the sum of the two companies

operating as independent entities.

Exactly what we would expect given that the merger provided no synergies, and

no control premium was paid.

The practice of seeking to apply Bidder P/E ratios,

to merge earnings per share figures, is known as EPS Bootstrapping.

It's a problem particularly where firms with high P/E ratios

acquire firms with lower growth prospects and hence lower P/E ratios.

The next potentially dubious reason for

an acquisition is to diversify a firm's operation.

For example, back in March 2001, Kellogg's successfully launched

a $3.9 billion bid for cookie manufacturer Keebler Foods.

Kellogg's trumpeted to the market that that deal would

benefit shareholders as it would result in a more diversified portfolio.

But does that make sense from a shareholders perspective?

As a shareholder in a bidding firm like Kellogg's,

you need to ask yourself, why does it make sense for

the firm to diversify on my behalf instead of me doing it for myself?

For example, Kellogg's shareholders could have bought shares in Keebler Foods

themselves if they wanted to diversify into the cookie market.

And they could have done so

without paying the control premium that Kellogg's was forced to pay.

Now in other circumstances, where shareholders are unable to access

particular assets in particular markets themselves.

Then the diversification justification might hold more water.

For example, in January 2015 Kellogg's announced

that it had acquired control of Egyptian biscuit manufacturer Bisco Mazer.

An investment that shareholders back in the US might have found a little bit more

difficult to diversify into on their own.

So, in summary, there are quite a few valid economic justifications for

acquisition activity, including taking advantage of synergistic benefits,

replacing inefficient target management, increasing market power,

and reducing the company's tax liability.

There are, however, some potentially dubious reasons for

acquisition activity as well, including an increase in EPS,

which we have demonstrated does not necessarily result in an increase in

shareholder value.

And then secondly, diversification.

In our next session, we're going to flip things around, and ask how can value

be created not by getting bigger, but instead by getting smaller?

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