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MERGERS & ACQUISITIONS

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Mergers, Acquisitions, and Takeovers: What are the Differences?
Merger

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A strategy through which two firms agree to integrate their operations on a relatively co-equal basis

Acquisition

A strategy through which one firm buys a controlling, or 100% interest in another firm with the intent of making the acquired firm a subsidiary business within its portfolio
A special type of acquisition when the target firm did not solicit the acquiring firms bid for outright ownership

Takeover

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Adapted from Figure 7.1

MERGERS & ACQUISITIONS

Reasons for Acquisitions and Problems in Achieving Success

Cost new product development/increased speed to market

Acquisitions

Increased diversification

Increased market power

Avoiding excessive competition

Overcoming entry barriers

Lower risk compared to developing new products

Learning and developing new capabilities


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Market Power Acquisitions

MERGERS & ACQUISITIONS

Horizontal Acquisitions

Acquisition of a company in the same industry in

which the acquiring firm competes increases a


firms market power by exploiting: Cost-based synergies Revenue-based synergies

Acquisitions with similar characteristics result in


higher performance than those with dissimilar characteristics
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Market Power Acquisitions (contd)

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Horizontal Acquisitions Vertical Acquisitions

Acquisition of a supplier or distributor of one or more of the firms goods or services Increases a firms market power by controlling additional parts of the value chain

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Market Power Acquisitions (contd)

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Horizontal Acquisitions
Vertical Acquisitions Related Acquisitions

Acquisition of a company in a highly related industry

Because of the difficulty in implementing


synergy, related acquisitions are often difficult to implement

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Reasons for Acquisitions and Problems in Achieving Success

Adapted from Figure 7.1

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Too large

Acquisitions

Managers overly focused on acquisitions

Integration difficulties

Too much diversification

Inadequate evaluation of target

Large or extraordinary debt

Inability to achieve synergy


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Problems in Achieving Acquisition Success: Integration Difficulties


Integration challenges include: Melding two disparate corporate cultures Linking different financial and control systems Building effective working relationships (particularly when management styles differ) Resolving problems regarding the status of the newly acquired firms executives Loss of key personnel weakens the acquired firms capabilities and reduces its value

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Problems in Achieving Acquisition Success: Inadequate Evaluation of the Target


Due Diligence The process of evaluating a target firm for acquisition Ineffective due diligence may result in paying an excessive premium for the target company Evaluation requires examining: Financing of the intended transaction Differences in culture between the firms Tax consequences of the transaction Actions necessary to meld the two workforces

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Problems in Achieving Acquisition Success: Large or Extraordinary Debt


High debt can: Increase the likelihood of bankruptcy Lead to a downgrade of the firms credit rating Preclude investment in activities that contribute to the firms long-term success such as: Research and development Human resource training Marketing

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Problems in Achieving Acquisition Success: Inability to Achieve Synergy


Synergy exists when assets are worth more when used in conjunction with each other than when they are used separately Firms experience transaction costs when they use acquisition strategies

to create synergy
Firms tend to underestimate indirect costs when evaluating a potential acquisition

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Problems in Achieving Acquisition Success: Too Much Diversification


Diversified firms must process more information of greater diversity Scope created by diversification may cause managers to rely too much on financial rather than strategic controls to evaluate business units performances Acquisitions may become substitutes for innovation

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Problems in Achieving Acquisition Success: Managers Overly Focused on Acquisitions


Managers invest substantial time and energy in acquisition strategies in: Searching for viable acquisition candidates Completing effective due-diligence processes Preparing for negotiations Managing the integration process after the acquisition is completed

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Problems in Achieving Acquisition Success: Managers Overly Focused on Acquisitions


Managers in target firms operate in a state of virtual suspended animation during an acquisition Executives may become hesitant to make decisions with long-term consequences until negotiations have been completed The acquisition process can create a short-term perspective and a greater aversion to risk among executives in the target firm

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Problems in Achieving Acquisition Success: Too Large


Additional costs of controls may exceed the benefits of the economies of scale and additional market power Larger size may lead to more bureaucratic controls Formalized controls often lead to relatively rigid and standardized managerial behavior Firm may produce less innovation

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Attributes of Successful Acquisitions

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Adapted from Figure 7.2

MERGERS & ACQUISITIONS

Restructuring and Outcomes

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MERGERS & ACQUISITIONS

Explain why a company might decide to engage in corporate restructuring. Understand and calculate the impact on earnings and on market value of companies involved in mergers. Describe what benefits, if any, accrue to acquiring company shareholders and to selling company shareholders. Analyze a proposed merger as a capital budgeting problem.

Describe the merger process from its beginning to its conclusion.


Describe different ways to defend against an unwanted takeover. Discuss strategic alliances and understand how outsourcing has contributed to the formation of virtual corporations. Explain what divestiture is and how it may be accomplished. Understand what "going private" means and what factors may motivate management to take a company private. Explain what a leveraged buyout is and what risk it entails.
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Mergers and Other Forms of Corporate Restructuring

MERGERS & ACQUISITIONS

Sources of Value
Strategic Acquisitions Involving Common Stock Acquisitions and Capital Budgeting Closing the Deal

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Mergers and Other Forms of Corporate Restructuring

MERGERS & ACQUISITIONS

Takeovers, Tender Offers, and Defenses


Strategic Alliances Divestiture Ownership Restructuring

Leveraged Buyouts

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What is Corporate Restructuring?
Any change in a companys:

MERGERS & ACQUISITIONS

Capital structure,
Operations, or Ownership

that is outside its ordinary course of business.

So where is the value coming from (why restructure)?

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Sales enhancement and operating economies*

MERGERS & ACQUISITIONS

Why Engage in Corporate Restructuring?

Improved management
Information effect Wealth transfers Tax reasons

Leverage gains
Hubris hypothesis Managements personal agenda

* Will be discussed in more detail in the following two slides.

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MERGERS & ACQUISITIONS

Sales Enhancement and Operating Economies


Sales enhancement can occur because of market share gain, technological

advancements to the product table, and filling a gap in the product line.
Operating economies can be achieved because of the elimination of duplicate facilities or operations and personnel. Synergy -- Economies realized in a merger where the performance of the combined

firm exceeds that of its previously separate parts.

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Sales Enhancement and Operating Economies


Economies of Scale -- The benefits of size in which the average unit cost falls as

volume increases.

Horizontal merger: best chance for economies Vertical merger: may lead to economies

Conglomerate merger: few operating economies


Divestiture: reverse synergy may occur

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MERGERS & ACQUISITIONS

Strategic Acquisitions Involving Common Stock


Strategic Acquisition -- Occurs when one company acquires another as part of its overall business strategy.
When the acquisition is done for common stock, a ratio of exchange, which denotes the relative weighting of the two companies with regard to certain key

variables, results.
A financial acquisition occurs when a buyout firm is motivated to purchase the company (usually to sell assets, cut costs, and manage the remainder more efficiently), but keeps it as a stand-alone entity.

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Strategic Acquisitions Involving Common Stock


Example -- Company A will acquire Company B with shares of common stock. Company A Present earnings $20,000,000 Company B $5,000,000

Shares outstanding
Earnings per share Price per share Price / earnings ratio

5,000,000
$4.00 $64.00 16

2,000,000
$2.50 $30.00 12

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MERGERS & ACQUISITIONS

Strategic Acquisitions Involving Common Stock


Example -- Company B has agreed on an offer of $35 in common stock of Company A.

Surviving Company A

Total earnings Shares outstanding* Earnings per share

$25,000,000 6,093,750 $4.10

Exchange ratio = $35 / $64 = .546875 * New shares from exchange = .546875 x 2,000,000= 1,093,750

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MERGERS & ACQUISITIONS

Strategic Acquisitions Involving Common Stock


The shareholders of Company A will experience an increase in earnings per share
because of the acquisition [$4.10 post-merger EPS versus $4.00 pre-merger EPS]. The shareholders of Company B will experience a decrease in earnings per share because of the acquisition [.546875 x $4.10 = $2.24 post-merger EPS versus $2.50

pre-merger EPS].

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MERGERS & ACQUISITIONS

Strategic Acquisitions Involving Common Stock


Surviving firm EPS will increase any time the P/E ratio paid for a firm is less than
the pre-merger P/E ratio of the firm doing the acquiring. [Note: P/E ratio paid for Company B is $35/$2.50 = 14 versus pre-merger P/E ratio of 16 for Company A.]

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MERGERS & ACQUISITIONS

Strategic Acquisitions Involving Common Stock


Example -- Company B has agreed on an offer of $45 in common stock of Company A.

Surviving Company A Total earnings Shares outstanding* Earnings per share $25,000,000 6,406,250 $3.90

Exchange ratio = $45 / $64 = .703125


* New shares from exchange = .703125 x 2,000,000 = 1,406,250
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MERGERS & ACQUISITIONS

Strategic Acquisitions Involving Common Stock

The shareholders of Company A will experience a decrease in earnings per share


because of the acquisition [$3.90 post-merger EPS versus $4.00 pre-merger EPS]. The shareholders of Company B will experience an increase in earnings per share because of the acquisition [.703125 x $4.10 = $2.88 post-merger EPS versus $2.50

pre-merger EPS].

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MERGERS & ACQUISITIONS

Strategic Acquisitions Involving Common Stock


Surviving firm EPS will decrease any time the P/E ratio paid for a firm is greater than the pre-merger P/E ratio of the firm doing the acquiring. [Note: P/E ratio paid for Company B is $45/$2.50 = 18 versus pre-merger P/E ratio of 16 for Company A.]

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What About Earnings Per Share (EPS)?
Merger decisions should not be long-term consequences. The possibility of future earnings growth may outweigh the immediate dilution of earnings.
Expected EPS ($)

MERGERS & ACQUISITIONS

With the merger

made without considering the

Equal

Without the merger

Time in the Future (years) Initially, EPS is less with the merger. Eventually, EPS is greater with the merger.
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Market Value Impact
Market price per share of the acquiring company

MERGERS & ACQUISITIONS

Number of shares offered by the acquiring company for each share of the acquired company

Market price per share of the acquired company

The above formula is the ratio of exchange of market price.


If the ratio is less than or nearly equal to 1, the shareholders of the acquired firm are not likely to have a monetary incentive to accept the merger offer from the acquiring firm.

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Market Value Impact

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Example -- Acquiring Company offers to acquire Bought Company with shares of common stock at an exchange price of $40.

Acquiring Company
Present earnings Shares outstanding Earnings per share Price per share Price / earnings ratio $20,000,000 6,000,000 $3.33 $60.00 18

Bought Company
$6,000,000 2,000,000 $3.00 $30.00 10

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Market Value Impact
Exchange ratio Market price exchange ratio

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= $40 / $60 = .667 = $60 x .667 / $30 = 1.33 Surviving Company

Total earnings Shares outstanding* Earnings per share Price / earnings ratio Market price per share

$26,000,000 7,333,333 $3.55 18 $63.90

* New shares from exchange = .666667 x 2,000,000 = 1,333,333


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Market Value Impact

MERGERS & ACQUISITIONS

Notice that both earnings per share and market price per share have risen because

of the acquisition. This is known as bootstrapping.


The market price per share = (P/E) x (Earnings). Therefore, the increase in the market price per share is a function of an expected increase in earnings per share and the P/E ratio NOT declining.

The apparent increase in the market price is driven by the assumption that the P/E
ratio will not change and that each dollar of earnings from the acquired firm will be priced the same as the acquiring firm before the acquisition (a P/E ratio of 18).

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Empirical Evidence on Mergers
Target firms in a takeover
receive an average premium of 30%. Evidence on buying firms is

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CUMULATIVE AVERAGE ABNORMAL RETURN (%)

Selling companies

Buying companies

mixed. It is not clear that


acquiring firm shareholders gain. Some mergers do have synergistic benefits.

Announcement date TIME AROUND ANNOUNCEMENT (days)

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Developments in Mergers and Acquisitions


Roll-Up Transactions The combining of multiple small companies in the same industry

to create one larger company.

Idea is to rapidly build a larger and more valuable firm with the acquisition of small- and medium-sized firms (economies of scale).

Provide sellers cash, stock, or cash and stock.


Owners of small firms likely stay on as managers. If privately owned, a way to more rapidly grow towards going through an initial public offering (see Slide 22).

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Developments in Mergers and Acquisitions


An Initial Public Offering (IPO) is a companys first offering of common stock to the general public.
IPO Roll-Up An IPO of independent companies in the same industry that merge into a single company concurrent with the stock offering.

IPO funds are used to finance the acquisitions.

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Acquisitions and Capital Budgeting

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An acquisition can be treated as a capital budgeting project. This requires an

analysis of the free cash flows of the prospective acquisition.


Free cash flows are the cash flows that remain after we subtract from expected revenues any expected operating costs and the capital expenditures necessary to sustain, and hopefully improve, the cash flows.

Free cash flows should consider any synergistic effects but be before any financial
charges so that examination is made of marginal after-tax operating cash flows and net investment effects.

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Cash Acquisition and Capital Budgeting Example

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AVERAGE FOR YEARS (in thousands) 1 - 5 6 - 10 11 - 15 Annual after-tax operating cash flows from acquisition Net investment Cash flow after taxes $2,000 $1,800 600 300 $1,400 $1,500 $1,400 --$1,400

16 - 20 21 - 25
Annual after-tax operating cash flows from acquisition Net investment Cash flow after taxes $ 800 $ 200 --$ 800 $ 200 ---

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Cash Acquisition and Capital Budgeting Example

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The appropriate discount rate for our example free cash flows is the cost of capital for the acquired firm. Assume that this rate is 15% after taxes. The resulting present value of free cash flow is $8,724,000. This represents the maximum acquisition price that the acquiring firm should be willing to pay, if we do

not assume the acquired firms liabilities.


If the acquisition price is less than (exceeds) the present value of $8,724,000, then the acquisition is expected to enhance (reduce) shareholder wealth over the long run.

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Other Acquisition and Capital Budgeting Issues

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Noncash payments and assumption of liabilities


Estimating cash flows Cash-flow approach versus earnings per share (EPS) approach Generally, the EPS approach examines the acquisition on a short-run basis, while the cash-flow approach takes a more long-run view.

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Closing the Deal

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Consolidation -- The combination of two or more firms into an entirely new firm. The old firms cease to exist. Target is evaluated by the acquirer Terms are agreed upon Ratified by the respective boards

Approved by a majority (usually two-thirds) of shareholders from both firms


Appropriate filing of paperwork Possible consideration by The Antitrust Division of the Department of Justice or the Federal Trade Commission

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Taxable or Tax-Free Transaction

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At the time of acquisition, for the selling firm or its shareholders, the transaction is: Taxable -- if payment is made by cash or with a debt instrument. Tax-Free -- if payment made with voting preferred or common stock and the transaction has a business purpose. (Note: to be a tax-free transaction a few

more technical requirements must be met that depend on whether the purchase is
for assets or the common stock of the acquired firm.)

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Accounting Treatments

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Purchase (method) -- A method of accounting treatment for a merger based on the market price paid for the acquired company.

Pooling of Interests (method) -- A method of accounting treatment for a merger based on the net book value of the acquired companys assets. The balance sheets of the two companies were simply combined.

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Accounting Treatment of Goodwill

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Goodwill -- The intangible assets of the acquired firm arising from the acquiring firm paying more for them than their book value.

AS eliminated mandatory periodic amortization of goodwill for financial accounting purposes, but requires an impairment test (at least annually) to goodwill. Goodwill charges are generally deductible for tax purposes over 15 years for acquisitions occurring after August 10, 1993. An impairment to earnings is recognized when the book value of goodwill exceeds its market value by an amount that equals the difference.

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Tender Offers

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Tender Offer -- An offer to buy current shareholders stock at a specified price, often with

the objective of gaining control of the company. The offer is often made by another
company and usually for more than the present market price. Allows the acquiring company to bypass the management of the company it wishes to acquire.

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Tender Offers

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It is not possible to surprise another company with its acquisition because the SEC requires extensive disclosure.

The tender offer is usually communicated through financial newspapers and direct mailings if shareholder lists can be obtained in a timely manner.

A two-tier offer (next slide) may be made with the first tier receiving more favorable

terms. This reduces the free-rider problem.

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Two-Tier Tender Offer

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Two-tier Tender Offer Occurs when the bidder offers a superior first-tier price (e.g., higher amount or all cash) for a specified maximum number (or percent) of shares and simultaneously offers to acquire the remaining shares at a second-tier price.
Increases the likelihood of success in gaining control of the target firm. Benefits those who tender early.

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Defensive Tactics

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The company being bid for may use a number of defensive tactics including:

(1) persuasion by management that the offer is not in their best interests,
(2) taking legal actions, (3) increasing the cash dividend or declaring a stock split to gain shareholder support, and (4) as a last resort, looking for a friendly company (i.e., white knight) to purchase them.

White Knight -- A friendly acquirer who, at the invitation of a target company, purchases shares from the hostile bidder(s) or launches a friendly counter-bid in order to frustrate the initial, unfriendly bidder(s).

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Motivation Theories:
Managerial Entrenchment Hypothesis

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Antitakeover Amendments and Other Devices

This theory suggests that barriers are erected to protect management jobs and that such actions work to the detriment of shareholders.

Shareholders Interest Hypothesis This theory implies that contests for corporate control are dysfunctional and take management time away from profit-making activities.

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Antitakeover Amendments and Other Devices


Shark Repellent -- Defenses employed by a company to ward off potential takeover bidders -- the sharks. Stagger the terms of the board of directors Change the state of incorporation Supermajority merger approval provision

Fair merger price provision


Leveraged recapitalization Poison pill Standstill agreement

Premium buy-back offer

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Empirical Evidence on Antitakeover Devices


Empirical results are mixed in determining if antitakeover devices are in the best

interests of shareholders.
Standstill agreements and stock repurchases by a company from the owner of a large block of stocks (i.e., greenmail) appears to have a negative effect on shareholder wealth. For the most part, empirical evidence supports the management entrenchment hypothesis because of the negative share price effect.

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Strategic Alliance

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Strategic Alliance -- An agreement between two or more independent firms to cooperate in order to achieve some specific commercial objective.

Strategic alliances usually occur between (1) suppliers and their customers, (2) competitors in the same business, (3) non-competitors with complementary strengths.

A joint venture is a business jointly owned and controlled by two or more independent firms. Each venture partner continues to exist as a separate firm, and the joint venture represents a new business enterprise.

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Divestiture

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Divestiture -- The divestment of a portion of the enterprise or the firm as a whole.

Liquidation -- The sale of assets of a firm, either voluntarily or in bankruptcy. Sell-off -- The sale of a division of a company, known as a partial sell-off, or

the company as a whole, known as a voluntary liquidation.

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Divestiture

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Spin-off -- A form of divestiture resulting in a subsidiary or division becoming an

independent company. Ordinarily, shares in the new company are distributed to


the parent companys shareholders on a pro rata basis. Equity Carve-out -- The public sale of stock in a subsidiary in which the parent usually retains majority control.

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Empirical Evidence on Divestitures

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For liquidation of the entire company, shareholders of the liquidating company realize

a +12 to +20% return.


For partial sell-offs, shareholders selling the company realize a slight return (+2%). Shareholders buying also experience a slight gain. Shareholders gain around 5% for spin-offs.

Shareholders receive a modest +2% return for equity carve-outs.


Divestiture results are consistent with the informational effect as shown by the positive market responses to the divestiture announcements.

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Ownership Restructuring

MERGERS & ACQUISITIONS

Going Private -- Making a public company private through the repurchase of stock by current management and/or outside private investors.

The most common transaction is paying shareholders cash and merging the company

into a shell corporation owned by a private investor management group.


Treated as an asset sale rather than a merger.

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MERGERS & ACQUISITIONS

Motivation and Empirical Evidence for Going Private


Motivations:
Elimination of costs associated with being a publicly held firm (e.g., registration, servicing of shareholders, and legal and administrative costs related to SEC regulations and reports).

Reduces the focus of management on short-term numbers to long-term wealth


building. Allows the realignment and improvement of management incentives to enhance wealth building by directly linking compensation to performance without having to answer to the public.

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MERGERS & ACQUISITIONS

Motivation and Empirical Evidence for Going Private


Motivations (Offsetting Arguments):
Large transaction costs to investment bankers. Little liquidity to its owners. A large portion of management wealth is tied up in a single investment. Empirical Evidence: Shareholders realize gains (+12 to +22%) for cash offers in these transactions.

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Ownership Restructuring

MERGERS & ACQUISITIONS

Leverage Buyout (LBO) -- A primarily debt financed purchase of all the stock or assets
of a company, subsidiary, or division by an investor group.

The debt is secured by the assets of the enterprise involved. Thus, this method is generally used with capital-intensive businesses. A management buyout is an LBO in which the pre-buyout management ends up with a substantial equity position.

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Common characteristics (not all necessary):

MERGERS & ACQUISITIONS

The company has gone through a program of heavy capital expenditures (i.e.,
modern plant).

There are subsidiary assets that can be sold without adversely impacting the core business, and the proceeds can be used to service the debt burden.

Stable and predictable cash flows.


A proven and established market position. Less cyclical product sales. Experienced and quality management.

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