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• Firms make acquisitions to create value for shareholders

• Reasons often cited for making acquisitions– improve the performance of the company– consolidate to remove excess capacity from an industry– create market access for the target’s (or in some cases,

the acquirer’s) products– acquire skills or technologies more quickly or at lower

cost than they can be built in-house– pick winners early and help them develop their business– consolidate to improve competitive behavior– enter into a transformational merger

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• A common reason often cited in M&As is improvements in operating performance (i.e., synergies)– Operating synergies often take the form of cost

savings or revenue enhancements, for the combined firm. • Cost savings can come from many sources: R&D,

procurement, manufacturing, sales and marketing, distribution, and administration. Cost savings typically manifests itself through higher operating margins.

• Revenue enhancements can come from increased market share (higher growth), or longer high growth period.

• McKinsey & Company find that companies are better at estimating cost savings than revenue enhancements.

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– Financial synergies can come from an increase in debt capacity, tax benefits, and mergers between firms with excess cash (low growth opportunities) and high growth firms that are cash poor.

• Other theories to explain acquisitions– Hubris – empire building on the part of the

acquirer– Agency problems – the target’s performance could

be improved by changing control

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• We will focus on majority, active investments --- investments where the acquirer owns 50 percent or more of the voting stock of another company. In such cases, the acquirer is said to control the acquired company.

• Two forms:– Merger: the acquirer assumes all the assets and

liabilities of the target company, after which the target no longer exists as a separate entity

– Acquisition: the acquirer buys some or all of the stock or assets of the target. The target becomes a subsidiary of the acquirer.

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• Accounting – In the U.S., all business combinations after June

30, 2011 use the purchase (vs. pooling) method of accounting. The main difference between the two methods is that the purchase method allows acquiring companies not to amortize goodwill, provided it is periodically tested for impairment.• Goodwill is the difference between the acquisition price

for the target’s equity and the fair value of its net assets (i.e., assets – liabilities)

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• Accounting – Example --- please refer to handouts given in class.

Specifically, Exhibits 7.12, 7.16, and 7.17– Accretive vs dilutive deals• Accretive (dilutive) deals refer to cases where the EPS

of the acquirer, or the combined company, increases (decreases) after accounting for the acquisition• Not all accretive deals are good (e.g., serial acquirers

may do deals just to keep showing growth in EPS); not all dilutive deals are bad• Always examine the strategic fit between the acquirer

and the target to determine whether synergy claims are plausible (i.e., the transaction will have a positive NPV)

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• Sources:– McKinsey & Company, Koller, Goedhardt, and Wessels,

Valuation: Measuring and managing the value of companies, 5th ed.

– Arzac. Valuation for mergers, buyouts, and restructuring, 2nd ed.

– Wahlen, Baginski, Bradshaw. Financial reporting, financial statement analysis, and valuation, 7th ed.