When we talk about acquisitions or takeovers, we are talking about a number of different transactions. These transactions can range from one firm merging with another firm to create a new firm to managers of a firm acquiring the firm from its stockholders and creating a private firm. We begin this section by looking at the different forms taken by takeovers.
1. TAKEOVER
A corporate action where an acquiring company makes a bid for an acquire. If the target company is publicly traded, the acquiring company will make an offer for the outstanding shares.
There are three types of takeovers:
1.1 Friendly takeovers
A "friendly takeover" is an acquisition which is approved by the management. Before a bidder makes an offer for another company, it usually first informs the company's board of directors. In an ideal world, if the board feels that accepting the offer serves the shareholders better than rejecting it, it recommends the offer be accepted by the shareholders.
1.2 Hostile takeovers
A "hostile takeover" allows a suitor to take over a target company whose management is unwilling to agree to a merger or takeover. A takeover is considered "hostile" if the target company's board rejects the offer, but the bidder continues to pursue it, or the bidder makes the offer directly after having announced its firm intention to make an offer.
A hostile takeover can be conducted in several ways.
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A tender offer can be made where the acquiring company makes a public offer at a fixed price above the current market price.
An acquiring company can also engage in a proxy fight, whereby it tries to persuade enough shareholders, usually asimple majority, to replace the management with a new one which will approve the takeover.
Another method involves quietly purchasing enough stock on the open market, known as a "creeping tender offer", to effect a change in management. In all of these ways, management resists the acquisition, but it is carried out anyway.
1.3 Reverse takeovers
A "reverse takeover" is a type of takeover where a private company acquires a public company. This type of merger is used by private companies to become publicly traded without resorting to an initial public offering. Initially, the private company buys enough shares to control a publicly traded company. The private company's shareholder
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then uses their shares in the private company to exchange for shares in the public company. At this point, the private company has effectively become a publicly traded one.
2. ACQUISITION
A corporate action in which a company buys most, if not all, of the target company's ownership stakes in order to assume control of the target firm. Acquisitions are often made as part of a company's growth strategy whereby it is more beneficial to take over an existing firm's operations and niche compared to expanding on its own. Acquisitions are often paid in cash, the acquiring company's stock or a combination of both.
2.1. Classifying Acquisitions
There are several ways in which a firm can be acquired by another firm.
a. Merger
In a merger, the boards of directors of two firms agree to combine and seek stockholder approval for the combination. In most cases, at least 50% of the shareholders of the target and the bidding firm have to agree to the merger.
b. Tenderoffer
In a tender offer, one firm offers to buy the outstanding stock of the other firm at a specific price and communicates this offer in advertisements and mailings to stockholders.
By doing so, it bypasses the incumbent management and board of directors of the target firm. Consequently, tender offers are used to carry out hostile takeovers. The acquired firm will continue to exist as long as there are minority stockholders who refuse the tender.
c. Purchase of assets
In a purchase of assets, one firm acquires the assets of another, though a formal vote by the shareholders of the firm being acquired is still needed. Target firm remains as a shell company, but its assets are transferred to the acquiring firm. Ultimately, target firm is liquidated.
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2.2. The Process and step of an Acquisition
Acquisitions can be friendly or hostile events. In a friendly acquisition, the managers of the target firm welcome the acquisition and, in some cases, seek it out. In a hostile acquisition, the target firm’s management does not want to be acquired. The acquiring firm offers a price higher than the target firm’s market price prior to the acquisition and invites stockholders in the target firm to tender their shares for the price.
The difference between the acquisition price and the market price prior to the acquisition is called the acquisition premium. The acquisition price is the one that will be paid by the acquiring firm for each of the target firm’s shares. This price is usually based upon negotiations between the acquiring firm and the target firm’s managers.
For instance, in 1991, AT&T initially offered to buy NCR for $ 80 per share, a premium of $ 25 over the stock price at the time of the offer. AT&T ultimately paid $ 110 per share to complete the acquisition. There is other comparison that can be made between the price paid on the acquisition and the accounting book value of the equity in the firm being acquired.
Depending upon how the acquisition is accounted for, this difference will be recorded as goodwill on the acquiring firm’s books or not be recorded at all.
Initially offered to buy: $80 per share Premium: $25 per share
Paid: $110 per share
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There are four basic and not necessarily sequential steps, in acquiring a target firm.
The first is the development of a rationale and a strategy for doing acquisitions, and the understanding of what the strategy requires in terms of resources. The second is the choice of a target for the acquisition and the valuation of the target firm, with premiums for the value of control and any synergy. The third is the determination of how much to pay on the acquisition, how best to raise funds to do it, and whether to use stock or cash.
This decision has significant implications for the choice of accounting treatment for the acquisition. The final step in the acquisition, and perhaps the most challenging one, is to make the acquisition work after the deal is complete.
2.3 Create Operating or Financial Synergy
Synergy is the potential additional value from combining two firms. It is probably the most widely used and misused rationale for mergers and acquisitions.
Synergy is a stated motive in many mergers and acquisitions. A number of studies examine whether synergy exists and, if it does, how much it is worth. If synergy is perceived to exist in a takeover, the value of the combined firm should be greater than the sum of the values of the bidding and target firms, operating independently.
V (AB) > V (A) + V (B) where
V (AB) = Value of a firm created by combining A and B (Synergy) V (A) = Value of firm A, operating independently
V (B) = Value of firm B, operating independently
2.4. Valuing the Target Firm
The valuation of an acquisition includes the existence of control and synergy premiums Given the inter-relationship between synergy and control, the safest way to value a target firm is in steps, starting with a status quo valuation of the firm, and following up with a value for control and a value for synergy.
a. Status Quo Valuation
We start our valuation of the target firm by estimating the firm value with existing investing, financing and dividend policies. This valuation, which we term the status quo valuation, provides a base from which we can estimate control and synergy premiums.
Example: A Status Quo Valuation of Digital
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In 1997, Digital Equipment was the target of an acquisition bid by Company. To analyse the acquisition, we begin with a status quo valuation of Digital. At the time of the acquisition, Digital had the following characteristics:
-Digital had earnings before interest and taxes of $391.38 million in 1997, -Pre-tax operating margin of 3% on revenues of $13,046 million
After-tax return on capital of 8.51%; the firm had a tax rate of 36%.
- Based upon its beta of 1.15, an after-tax cost of borrowing of 5% and a debt ratio of approximately 10%, the cost of capital for Digital in 1997 was 11.59%. (The treasury bond rate at the time of the analysis was 6%.)
1. Cost of Equity = 6% + 1.15 (5.5%) = 12.33%
2. Cost of Capital = 12.33% (.9) + 5% (.1) = 11.59%
- Digital had capital expenditures of $475 million,
-Depreciation of $ 461 million, and working capital is 15% of revenues.
Operating income, net capital expenditures and revenues were expected to grow 6% a year for the next 5 years. After year 5, operating income and revenues were expected to grow 5% a year forever. After year 5, capital expenditures were expected to be 110% of depreciation. The debt ratio remained at 10%, but the after-tax cost of debt dropped to 4% and the beta dropped to 1.
The value of Digital, based upon these inputs, was estimated to be $2,110.41 million. 2.5. Example
Note that the terminal value is computed using the free cash flow to the firm in year 6 and the new cost of capital after year 5.
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New cost of equity after year 5 = 6% + 1.00 (5.5%) = 11.5%
New cost of capital after year 5 = 11.50% (0.9) + 4% (0.1) = 10.75%
Terminal value = $156.25 / (0.1075 - 0.05) = $2,717.35 a) The Value of Control at Digital
Assuming that Compaq was correct in its perceptions, we valued control at Digital by making the following assumptions:
-Digital will raise its debt ratio to 20%. The beta will increase, but the cost of capital will decrease.
-New Beta = 1.25 (Unlevered Beta = 1.07; Debt/Equity Ratio = 25%)
-Cost of Equity = 6% + 1.25 (5.5%) = 12.88%
-New After-tax Cost of Debt = 5.25%; the firm is riskier, and its default risk increase. -Cost of Capital = 12.88% (0.8) + 5.25% (0.2) = 11.35%
-Digital will raise its return on capital to 11.35%, which is its cost of capital. (Pre-tax Operating margin will go up to 4%, which is close to the industry average)
-The reinvestment rate remains unchanged, but the increase in the return on capital will increase the expected growth rate in the next 5 years to 10%.
-After year 5, the beta will drop to 1, and the after-tax cost of debt will decline to 4%, as in the previous example.
The effect of these assumptions on the cash flows and present values.
The lower cost of capital and higher growth rate increase the firm value from the status quo valuation of $2,110.41 million to $4,531.59 million. We can then estimate the value of control.
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Value of firm (optimally managed) = $4,531.59 million
Value of firm (status quo) = $2,110.41 million
Value of control = $2,421.18 million  Value of Control = Value of firm, optimally managed - Value of firm with current management.
b) Valuing Synergy: Compaq and Digital
Returning to the Compaq/Digital merger, to value this synergy, we needed to first value Compaq as a stand-alone firm. To do this, we made the following assumptions. -Compaq had earnings before interest and taxes of $2,987 million on revenues of $25,484 million.
-The tax rate for the firm is 36%.
-The firm had capital expenditures of $ 729 million and depreciation of $545 million in the most recent year;
-Working capital is 15% of revenues.
- The firm had a debt to capital ratio of 10%, a beta of 1.25, and an after-tax cost of debt of 5%.
- The operating income, revenues and net capital expenditures are all expected to grow 10% a year for the next 5 years.
-After year 5, operating income and revenues are expected to grow 5% a year forever, and capital expenditures are expected to be 110% of depreciation. In addition, the firm will raise its debt ratio to 20%, the after-tax cost of debt will drop to 4% and the beta will drop to 1.00.
Based upon these inputs, the value of the firm can be estimated as follows:
The value of Compaq is $38.547 billion.
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The value of the combined firm (Compaq+Digital), with no synergy, should be the sum of the values of the firms valued independently. To avoid double counting the value of control, we add the value of Digital, optimally managed, to the value of Compaq to arrive at the value of the combined firm:
Value of Digital (optimally managed)= $4,531.59 million Value of Compaq (status quo) = $38,546.91 million
Value of combined firm = $43,078.50 million. This would be the value of the combined firm in the absence of synergy.
To value the synergy, we made the following assumptions about the way in which synergy would affect cash flows and discount rates at the combined firm.
-The combined firm will have some economies of scale, allowing it to increase its current after-tax operating margin slightly. The annual dollar savings will be approximately $100 million. This will translate into a slightly higher pre-tax operating margin
The combined firm will also have a slightly higher growth rate of 10.50% over the next 5 years, because of operating synergies.
-The beta of the combined firm was computed in three steps. We first estimated the unlevered betas for Digital and Compaq.
We then weighted these unlevered betas by the values of these firms to estimate an unlevered beta for the combined firm;
 Digital has a firm value6 of $4.5 billion 11
 Compaq’s firm value was $38.6 billion
 Unlevered Beta for combined firm= (1.07)(4.5/43.1) + (1.17)(38.6/43.1)= 1.16 Based on these assumptions, the cash flows and value of the combined firm, with synergy, can be estimated:
The value of the combined firm, with synergy, is $45,510.58 million. This can be compared to the value of the combined firm, without synergy, of $43,078.50 million, and the difference is the value of the synergy in the merger.
 Value of combined firm (with synergy) = $45,510.58 million
 Value of combined firm (with no synergy) = $43,078.50 million
 Value of Synergy = $ 2,422.08 million
This valuation is based on the presumption that synergy will be created instantaneously. In reality, it can take years before the firms are able to see the benefits of synergy. A simple way to account for the delay is to consider the present value of synergy. Thus, if it will take Compaq and Digital three years to create the synergy, the present value of Synergy can be estimated, using the combined firm’s cost of capital as the discount rate.
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3. CONCLUSION
Acquisitions take several forms and occur for different reasons. Acquisitions can be categorized, based upon what happens to the target firm after the acquisition. A target firm can be consolidated into the acquiring entity (merger), create a new entity in combination with the acquiring firm or remain independent.
There are four steps in analysing acquisitions. First, we specify the reasons for acquisitions and we choose a target to value, assuming it would continue to be run by its current managers and then revalue it assuming better management. We define the difference between these two values as the value of control. We also value each of the different sources of operating and financial synergy and considered the combined value as the value of total synergy.