Mergers and Acquisitions

Suppose you decide to sell your car. Two buyers come to look at it; one offers you $5,000 and the other offers you $5,200. Which offer do you take? If you have been paying attention throughout this book, you take the $5,200. That's exactly what the board and shareholders of the giant bank Wachovia didn't do in the summer of 2001. In a bitter battle for Wachovia, First Union offered $14.6 billion, while rival SunTrust offered $15.3 billion. Nonetheless, Wachovia's shareholders voted to accept the First Union bid, thereby following the recommendation of Wachovia's board. Why did they take a lower offer? This chapter explores reasons for mergers to take place, and just as important, reasons why they should not.

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. It is the stuff of headlines in the financial press, and it is occasionally an embarrassing source of scandal.

The acquisition of one firm by another is, of course, an investment made under uncertainty, and the basic principles of valuation apply. One firm should acquire another only if doing so generates a positive net present value for the shareholders of the acquiring firm. However, because the NPV of an acquisition candidate can be difficult to determine, mergers and acquisitions are interesting topics in their own right.

Some of the special problems that come up in this area of finance include the following:

1. The benefits from acquisitions can depend on such things as strategic fits. Strategic fits are difficult to define precisely, and it is not easy to estimate the value of strategic fits using discounted cash flow techniques.

2. There can be complex accounting, tax, and legal effects that must be taken into account when one firm is acquired by another.

3. Acquisitions are an important control device for shareholders. Some acquisitions are a consequence of an underlying conflict between the interests of existing managers and those of shareholders. Agreeing to be acquired by another firm is one way that shareholders can remove existing managers.

An excellent source of merger data online is found at

www.mergers.com.,

For up-to-date information on happenings in the world of M&A, go to cbs.marketwatch.com, then type "merger" into its search option.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VIII. Topics in Corporate Finance

25. Mergers and Acquisitions

© The McGraw-Hill Companies, 2002

Michael C. Jensen on Mergers and Acquisitions

Economic analysis and evidence indicate that takeovers, LBOs, and corporate restructurings are playing an important role in helping the economy adjust to major competitive changes in the last two decades. The competition among alternative management teams and organizational structures for control of corporate assets has enabled vast economic resources to move more quickly to their highest-valued use. In the process, substantial benefits for the economy as a whole as well as for shareholders have been created. Overall gains to selling-firm shareholders from mergers, acquisitions, leveraged buyouts, and other corporate restructurings in the 12-year period from 1977 through 1988 total over $500 billion in 1988 dollars. I estimate gains to buying-firm shareholders to be at least $50 billion for the same period. These gains equal 53 percent of the total cash dividends (valued in 1988 dollars) paid to investors by the entire corporate sector in the same period.

Mergers and acquisitions are a response to new technologies or market conditions that require a strategic change in a company's direction or use of resources. Compared to current management, a new owner is often better able to accomplish major change

© The McGraw-Hill Companies, 2002

in the existing organizational structure. Alternatively, leveraged buyouts bring about organizational change by creating entrepreneurial incentives for management and by eliminating the centralized bureaucratic obstacles to maneuverability that are inherent in large public corporations.

When managers have a substantial ownership interest in the organization, the conflicts of interest between shareholders and managers over the payout of the company's free cash flow are reduced. Management's incentives are focused on maximizing the value of the enterprise, rather than building empires—often through poorly conceived diversification acquisitions—without regard to shareholder value. Finally, the required repayment of debt replaces management's discretion in paying dividends and the tendency to overretain cash. Substantial increases in efficiency are thereby created.

Michael C. Jensen is Edsel Bryant Ford Professor of Business Administration at Harvard University. An outstanding scholar and researcher, he is famous for his pathbreaking analysis of the modern corporation and its relations with its stockholders.

4. Mergers and acquisitions sometimes involve "unfriendly" transactions. In such cases, when one firm attempts to acquire another, the activity does not always confine itself to quiet, genteel negotiations. The sought-after firm often resists takeover and may resort to defensive tactics with exotic names such as poison pills, greenmail, and white knights.

We discuss these and other issues associated with mergers in the sections that follow.

We begin by introducing the basic legal, accounting, and tax aspects of acquisitions.

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