CHAPTER 30

Mergers and Acquisitions

EXECUTIVE SUMMARY
There is no more dramatic or controversial activity in corporate finance than the acquisition of one firm by another or the
merger of two firms. This chapter addresses two basic questions: Why does a firm choose to merge with or acquire
another firm and how does it happen?
The acquisition of one firm by another is, of course, an investment made under uncertainty. The basic principle of
valuation applies: a firm should be acquired if it generates a positive net present value to the shareholders of the
acquiring firm. However, because the NPV of an acquisition candidate is very difficult to determine, mergers and
acquisitions are interesting topics in their own right. Here are some of the special features of this area of finance:

1. The benefits from acquisitions are called synergies. It is hard to estimate synergies using discounted cash flow
techniques.
2. There are complex accounting, tax, and legal effects when one firm is acquired by another.
3. Acquisitions are an important control device of shareholders. It appears that some acquisitions are a consequence of an
underlying conflict between the interests of existing
managers and of shareholders. Acquisition by another firm is one way that shareholders
can remove managers with whom they are unhappy.
4. Acquisition analysis frequently focuses on the total value of the firms involved. But usually an acquisition will affect
the relative values of stocks and bonds, as well as their total value.
5. Mergers and acquisitions sometimes involve unfriendly transactions. Thus, when one firm attempts to acquire another,
it does not always involve quiet, gentlemanly negotiations. The sought-after firm may use defensive tactics, including
poison pills, greenmail, and white knights.
This chapter starts by introducing the basic legal, accounting, and tax aspects of acquisitions. When one firm acquires
another, it must choose the legal framework, the accounting method, and tax status. These choices will be explained
throughout the chapter. The chapter discusses how to determine the NPV of an acquisition candidate. The NPV of an
acquisition candidate is the difference between the synergy from the merger and the premium to be paid. We consider the
following types of synergy: (1) revenue enhancement, (2) cost reduction, (3) lower taxes, and (4) lower cost of capital.
The premium paid for an acquisition is the price paid minus the market value of the acquisition prior to the merger. The
premium depends on whether cash or securities are used to finance the offer price.

30.2 THE TAX FORMS OF ACQUISITIONS

If one firm buys another firm, the transaction may be taxable or tax-free. In a taxable acquisition, the shareholders of the
acquired firm are considered to have sold their shares, and they have realized capital gains or losses that will be taxed. In
a taxable transaction, the appraised value of the assets of the selling firm may be revalued, as we explain below. In a tax
free acquisition, the selling shareholders are considered to have exchanged their old shares for new ones of equal value,
and they have experienced no capital gains or losses. In a tax-free acquisition, the assets are not revalued.

EXAMPLE
Suppose that 15 years ago Bill Evans started Samurai Machinery (SM) and purchased plant and equipment costing
$80,000. These have been the only assets of SM, and the company has no debts. Bill is the sole proprietor of SM and
owns all the shares. For tax purposes the assets of SM have been depreciated using the straight-line method over 10
years, and have no salvage value. The annual depreciation expense has been $8,000 ($80,000/10). The machinery has no
accounting value today (i.e., it has been written off the books). However, because of inflation, the fair market value of the
machinery is $200,000. As a consequence, the S. A. Steel Company has bid $200,000 for all of the outstanding stock of
Samurai.
Tax-Free Transaction: If Bill Evans receives shares of S. A. Steel worth $200,000, the IRS will treat the sale as a tax-
free transaction. Thus, Bill will not have to pay taxes on any gain received from the stock. In addition, S. A. Steel will be
allowed the same depreciation deduction that Samurai Machinery was allowed. Because the asset has already been fully
depreciated, S. A. Steel will receive no depreciation deduction.
Taxable Transaction: If S. A. Steel pays $200,000 in cash for Samurai Machinery, it will be a taxable transaction.
There will be a number of tax consequences:
1. In the year of the merger, Bill Evans must pay taxes on the difference between the merger price of $200,000 and his
initial contribution to the firm of $80,000. Thus, his taxable income is $120,000 ($200,000- $80,000).
2. S. A. Steel may elect to write up the value of the machinery. In this case, S. A. Steel will be able to depreciate the
machinery from an initial tax basis of $200,000. If S. A. Steel depreciates straight-line over 10 years, depreciation will be
$20,000 ($200,000/10) per year. If S. A. Steel elects to write up the machinery, S. A. Steel must treat the $200,000
write-up as taxable income immediately.
3. Should S. A. Steel not elect the write-up, there is no increase in depreciation. Thus, depreciation remains zero in this
example. In addition, because there is no write-up, S. A. Steel does not need to recognize any additional taxable income.

Because the tax benefits from depreciation occur slowly over time and the taxable income is recognized immediately, the
acquirer generally elects not to write up the value of the machinery in a taxable transaction. Because the write-up is not
allowed for tax-free transactions and generally not chosen for taxable ones, the only real tax difference between the two
types of transactions concerns the taxation of the selling shareholders. Because these individuals can defer taxes under a
tax-free situation but must pay taxes immediately under a taxable situation, the tax-free transaction has better tax
consequences. The tax implications for both types of transactions are displayed in Table 30.1.

30.4 DETERMINING THE SYNERGY FROM AN ACQUISITION

Suppose firm A is contemplating acquiring firm B. The value of firm A is VA and the value
of firm B is VB. (It is reasonable to assume that, for public companies, VA and VB can be determined by observing the
market price of the outstanding securities.) The difference between the value of the combined firm (VAB) and the sum of
the values of the firms as separate entities is the synergy from the acquisition:

Synergy = VAB - (VA + VB)

7. Cash versus Stock Payment Penn Corp. is analyzing the possible acquisition of Teller Company. Both
firms have no debt. Penn believes the acquisition will increase its total after-tax annual cash flow by $1.6
million indefinitely. The current market value of Teller is $65 million, and that of Penn is $98 million. The
appropriate discount rate for the incremental cash flows is 12 percent. Penn is trying to decide whether it
should offer 40 percent of its stock or $70 million in cash to Teller’s shareholders.
1. What is the cost of each alternative?
2. What is the NPV of each alternative?
3. Which alternative should Penn choose?
 Ans: 1. The cash cost is the amount of cash offered, so the cash cost is $70 million. To calculate the cost of the stock
offer, we first need to calculate the value of the target to the acquirer. The value of the target firm to the acquiring
firm will be the market value of the target plus the PV of the incremental cash flows generated by the target firm. The
cash flows are a perpetuity, so
V* = $65,000,000 + $1,600,000/.12 = $78,833,333
The cost of the stock offer is the percentage of the acquiring firm given up times the sum of the market value of the
acquiring firm and the value of the target firm to the acquiring firm. So, the equity cost will be:
Equity cost = .40($98,000,000 + 78,833,333) = $70,533,333

2. The NPV of each offer is the value of the target firm to the acquiring firm minus the cost of
acquisition, so:
NPV cash = $78,333,333 – 70,000,000 = $8,333,333
NPV stock = $78,333,333 – 70,533,333 = $7,800,000

3. Since the NPV is greater with the cash offer, the acquisition should be in cash

10. Cash versus Stock as Payment Consider the following premerger information about a bidding firm (firm
B) and a target firm (firm T). Assume that both firms have no debt outstanding.

Firm B has estimated that the value of the synergistic benefits from acquiring firm T is $5,500.
1. If firm T is willing to be acquired for $29 per share in cash, what is the NPV of the
merger?
2. What will the price per share of the merged firm be assuming the conditions in (a)?
3. In part (a), what is the merger premium?
4. Suppose firm T is agreeable to a merger by an exchange of stock. If B offers three of its
shares for every five of T’s shares, what will the price per share of the merged firm be?
5. What is the NPV of the merger assuming the conditions in (d)?
 Ans: 1. The NPV of the merger is the market value of the target firm, plus the value of the synergy, minus the
acquisition costs, so:
NPV = 1,400($26) + $5,500 – 1,400($29) = $1,300
2. Since the NPV goes directly to stockholders, the share price of the merged firm will be the market value of the
acquiring firm plus the NPV of the acquisition, divided by the number of shares outstanding, so:
Share price = [2,900($39) + $1,300]/2,900 = $39.45
3. The merger premium is the premium per share times the number of shares of the target firm outstanding, so the
merger premium is:
Merger premium = 1,400($29 – 26) = $4,200
4. The number of new shares will be the number of shares of the target times the exchange ratio, so:
New shares created = 1,400(3/5) = 840 new shares
The value of the merged firm will be the market value of the acquirer plus the market value of the target plus the
synergy benefits, so:
VBT = 2,900($39) + 1,400($26) + 5,500 = $155,000
The price per share of the merged firm will be the value of the merged firm divided by the total shares of the new
firm, which is:
P = $155,000/(2,900 + 840) = $41.44
5. The NPV of the acquisition using a share exchange is the market value of the target firm plus synergy benefits,
minus the cost. The cost is the value per share of the merged firm times the number of shares offered to the target
firm shareholders, so:
NPV = 1,400($26) + $5,500 – 840($41.44) = $7,087.17

Mam’s Note/exercise/Problem on ZOOM: