Part Ten: Mergers, Corporate Control, and Governance

Mergers

The scale and pace of merger activity in the United States have been remarkable. Table 31.1 lists just a few recent mergers. Notice the high proportion of cross-border mergers between firms in different countries. Look also at Figure 31.1, which shows the number of mergers involving U.S. companies for each year from 1985 to 2017. In 2017, a record year for merger activity, companies were involved in 15,000 deals totaling $1.7 trillion. During such periods of intense merger activity, management spends significant amounts of time either searching for firms to acquire or worrying about whether some other firm will acquire them.

Industry	Acquiring Company	Selling Company	Payment ($ billions)
Telecom	AT&T	TimeWarner	$85
Chemicals	Dow Chemical	DuPont	79
Pharmacy/health insurance	CVS Health	Aetna	69
Agrichemicals	Bayer (Germany)	Monsanto	66
Eyewear	Essilor (France)	Luxottica (Italy)	54
Media	Disney	21st Century Fox	52
Tobacco	British American Tobacco (UK)	Reynolds American	49
Agrichemicals	China National Chemical (China)	Syngenta (Switzerland)	43
Semiconductors	Qualcomm	NXP Semiconductors (Holland)	38
Telecom	Comcast	Sky (UK)	31
Pharmaceuticals	Johnson & Johnson	Actelion (Switzerland)	30
Aerospace	United Technologies	Rockwell Collins	30
Food	Keurig Green Mountain	Dr Pepper Snapple	19
Railway transportation equipment	Siemens Mobility Division (Germany)	Alstom (France)	16
Food retailing	Amazon	Whole Foods	14

TABLE 31.1 Some important merger announcements in 2017

Note: Several of these mergers were pending and subject to regulatory approval. In other cases, there may be rival acquirers.

FIGURE 31.1 The number of mergers involving U.S. companies, 1985–2017

Source: Institute for Mergers, Acquisitions, and Alliances, https://imaa-institute.org

A merger adds value only if the two companies are worth more together than apart. This chapter covers why two companies could be worth more together and how to get the merger deal done if they are. Many marriages between companies are amicable, but sometimes one party is dragged unwillingly to the altar. So we also look at what is involved in hostile takeovers.

We proceed as follows:

· Motives. Sources of value added.

· Dubious motives. Don’t be tempted.

· Benefits and costs. It’s important to estimate them consistently.

· Mechanics. Legal, tax, and accounting issues.

· Takeover battles and tactics. We look at merger tactics and show some of the economic forces driving merger activity.

· Mergers and the economy. How can we explain merger waves? Who gains and who loses as a result of mergers?

Mergers are partly about economies from combining two firms, but they are also about who gets to run the company. Pick a merger, and you’ll almost always find that one firm is the protagonist and the other is the target. The top management of the target firm usually departs after the merger.

Financial economists now view mergers as part of a broader market for corporate control. The activity in this market goes far beyond ordinary mergers. It includes leveraged buyouts (LBOs), spin-offs, and divestitures, as well as nationalizations and privatizations where the government acquires or sells a business. These are the subject of the next chapter.

31-1Sensible Motives for Mergers

Mergers can be horizontal, vertical, or conglomerate. A horizontal merger is one that takes place between two firms in the same line of business. Most of the mergers listed in Table 31.1 are horizontal.

A vertical merger involves companies at different stages of production. The buyer expands back toward the source of raw materials or forward in the direction of the ultimate consumer. AT&T’s acquisition of Time Warner is an example. It has been described as a combination of a “pipe” and a “content” company; it gives AT&T control over the entertainment content that it had previously passed through to its customers.

A conglomerate merger involves companies in unrelated lines of businesses. For example, the Indian Tata Group is a huge, widely diversified company. Its acquisitions have been as diverse as Eight O’Clock Coffee, Corus Steel, Jaguar Land Rover, the Ritz Carlton (Boston), and British Salt. No U.S. company is as diversified as Tata, but in the 1960s and 1970s, it was common in the United States for unrelated businesses to merge. Much of the action in the 1980s and 1990s came from breaking up the conglomerates that had been formed 10 to 20 years earlier.

With these distinctions in mind, we are about to consider motives for mergers—that is, reasons two firms may be worth more together than apart. We proceed with some trepidation. The motives, though they often lead the way to real benefits, are sometimes just mirages that tempt unwary or overconfident managers into takeover disasters. This was the case for AOL, which in 2000 spent a record-breaking $156 billion to acquire Time Warner. The aim was to create a company that could offer consumers a comprehensive package of media and information products. It didn’t work.

Even more embarrassing was Bank of America’s 2008 acquisition of mortgage lender Countrywide for $4 billion. The bank’s chief executive hailed the acquisition as a rare chance to become No. 1 in home loans. But after the housing bubble burst, the soured loans made by Countryside ended up costing Bank of America an estimated $40 billion in operating losses, fines, and compensation payments.

Many mergers that seem to make economic sense fail because managers cannot handle the complex task of integrating two firms with different production processes, accounting methods, and corporate cultures. The nearby box shows how these difficulties bedeviled the merger of three Japanese banks.

The value of most businesses depends on human assets—managers, skilled workers, scientists, and engineers. If these people are not happy in their new roles in the merged firm, the best of them will leave. Beware of paying too much for assets that go down in the elevator and out to the parking lot at the close of each business day. They may drive into the sunset and never return.

Consider the $38 billion merger in 1998 between Daimler-Benz and Chrysler. Although it was hailed as a model for consolidation in the auto industry, the early years were rife with conflicts between two very different cultures:

German management-board members had executive assistants who prepared detailed position papers on any number of issues. The Americans didn’t have assigned aides and formulated their decisions by talking directly to engineers or other specialists. A German decision worked its way through the bureaucracy for final approval at the top. Then it was set in stone. The Americans allowed midlevel employees to proceed on their own initiative, sometimes without waiting for executive-level approval. . . .

Cultural integration also was proving to be a slippery commodity. The yawning gap in pay scales fueled an undercurrent of tension. The Americans earned two, three, and, in some cases, four times as much as their German counterparts. But the expenses of U.S. workers were tightly controlled compared with the German system. Daimler-side employees thought nothing of flying to Paris or New York for a half-day meeting, then capping the visit with a fancy dinner and a night in an expensive hotel. The Americans blanched at the extravagance.¹

Nine years after acquiring Chrysler, Daimler threw in the towel and announced that it was offloading an 80% stake in Chrysler to a leveraged-buyout firm, Cerberus Capital Management. Daimler actually paid Cerberus $677 million to take Chrysler off its hands. Cerberus in return assumed about $18 billion in pension and employee health care liabilities and agreed to invest $6 billion in Chrysler and its finance subsidiary.

There are also occasions when the merger does achieve gains but the buyer nevertheless loses because it pays too much. For example, the buyer may overestimate the value of stale inventory or underestimate the costs of renovating old plant and equipment, or it may overlook the warranties on a defective product. Buyers need to be particularly careful about environmental liabilities. If there is pollution from the seller’s operations or toxic waste on its property, the costs of cleaning up will probably fall on the buyer.

Now we turn to the possible sources of merger synergies—that is, the possible sources of added value.

FINANCE IN PRACTICE

Those Elusive Synergies

When three of Japan’s largest banks combined to form Mizuho Bank, the result was a bank with assets of $1.5 trillion, more than twice those of the world leader, Deutsche Bank. The name “Mizuho” means “rich rice harvest,” and the bank’s management fore-casted that the merger would yield a rich harvest of synergies. In a message to shareholders, the bank president claimed that the merger would create “a comprehensive financial services group that will surge forward in the 21st century.” He predicted that the bank would “lead the new era through cutting-edge comprehensive financial services . . . by exploiting to the fullest extent the Group’s enormous strengths, which are backed by a powerful customer base and state-of-the-art financial and information technologies.” The cost of putting the banks together was forecasted at ¥130 billion, but management predicted future benefits of ¥466 billion a year. Within a few months of the announcement, reports began to emerge of squabbles among the three partners. One problem area was IT. Each of the three merging banks had a different supplier for its computer system. At first, it was proposed to use just one of these three systems, but then the banks decided to connect the three different systems together using “relay” computers.

Three years after the initial announcement, the new company opened for business on April 1, 2002. Five days later, computer glitches resulted in a spectacular foul-up. Some 7,000 of the bank’s cash machines did not work, 60,000 accounts were debited twice for the same transaction, and millions of bills went unpaid. The Economist reported that two weeks later, Tokyo Gas, the biggest gas company, was still missing ¥2.2 billion in payments, and the top telephone company, NTT, which was looking for ¥12.7 billion, was forced to send its customers receipts marked with asterisks in place of figures because it did not know which of about 760,000 bills had been paid.

One of the objectives behind the formation of Mizuho was to exploit economies in its IT systems. The launch fiasco illustrated dramatically that it is easier to predict such merger synergies than to realize them.

Economies of Scale

Many mergers are intended to reduce costs and achieve economies of scale. For example,when Heinz and Kraft Foods announced plans to merge in 2015, they forecast annual cost savings of $1.5 billion by the end of 2017. These savings would mostly come from economies of scale in the North American market, where there would be opportunities to shut down less efficient manufacturing facilities and reduce labor costs. Also, the larger combined sales would help the company to drive better bargains with retailers and restaurants.²

Achieving these economies of scale is the natural goal of horizontal mergers. But such economies have been claimed in conglomerate mergers, too. The architects of these mergers have pointed to the economies that come from sharing central services such as office management and accounting, financial control, executive development, and top-level management.³

Economies of Vertical Integration

Vertical mergers seek to gain control over the production process by expanding back toward the output of the raw material or forward to the ultimate consumer. One way to achieve this is to merge with a supplier or a customer.

Vertical integration facilitates coordination and administration. We illustrate via an extreme example. Think of an airline that does not own any planes. If it schedules a flight from Boston to San Francisco, it sells tickets and then rents a plane for that flight from a separate company. This strategy might work on a small scale, but it would be an administrative nightmare for a major carrier, which would have to coordinate hundreds of rental agreements daily. In view of these difficulties, it is not surprising that all major airlines have integrated backward, away from the consumer, by buying and flying airplanes rather than simply patronizing rent-a-plane companies.

When trying to explain differences in integration, economists often stress the problems that may arise when two business activities are inextricably linked. For example, production of components may require a large investment in highly specialized equipment. Or a smelter may need to be located next to the mine to reduce the costs of transporting the ore. It may be possible in such cases to organize the activities as separate firms operating under a long-term contract. But such a contract can never allow for every conceivable change in the way that the activities may need to interact. Therefore, when two parts of an operation are highly dependent on each other, it often makes sense to combine them within the same vertically integrated firm, which then has control over how the assets should be used.⁴

Nowadays the tide of vertical integration seems to be flowing out. Companies are finding it more efficient to outsource the provision of many services and various types of production. For example, back in the 1950s and 1960s, General Motors was deemed to have a cost advantage over its main competitors, Ford and Chrysler, because a greater fraction of the parts used in GM’s automobiles were produced in-house. By the 1990s, Ford and Chrysler had the advantage: They could buy the parts cheaper from outside suppliers. This was partly because the outside suppliers tended to use nonunion labor at lower wages. But it also appears that manufacturers have more bargaining power versus independent suppliers than versus a production facility that’s part of the corporate family. In 1998 GM decided to spin off Delphi, its automotive parts division, as a separate company. After the spin-off, GM continued to buy parts from Delphi in large volumes, but it negotiated the purchases at arm’s length.

Complementary Resources

Many small firms are acquired by large ones that can provide the missing ingredients necessary for the small firms’ success. The small firm may have a unique product but lack the engineering and sales organization required to produce and market it on a large scale. The firm could develop engineering and sales talent from scratch, but it may be quicker and cheaper to merge with a firm that already has ample talent. The two firms have complementary resources—each has what the other needs—and so it may make sense for them to merge. Also, the merger may open up opportunities that neither firm would pursue otherwise.

In recent years, many of the major pharmaceutical firms have faced the loss of patent protection on their more profitable products and have not had an offsetting pipeline of promising new compounds. This has prompted an increasing number of acquisitions of biotech firms. For example, in 2017 Bristol Myers acquired IFM Therapeutics, a start-up company with two pre-clinical immunotherapy programs. Bristol Myers calculated that IFM’s drugs would fit well with its own range of immunotherapy treatments. At the same time, IFM obtained the resources that it needed to bring its products to market.

Surplus Funds

Here’s another argument for mergers: Suppose that your firm is in a mature industry. It is generating a substantial amount of cash, but it has few profitable investment opportunities. Ideally, such a firm should distribute the surplus cash to shareholders by increasing its dividend payment or repurchasing stock. Unfortunately, energetic managers are often reluctant to adopt a policy of shrinking their firm in this way. If the firm is not willing to purchase its own shares, it can instead purchase another company’s shares. Firms with a surplus of cash and a shortage of good investment opportunities often turn to mergers financed by cash as a way of redeploying their capital.

Some firms have excess cash and do not pay it out to stockholders or redeploy it by wise acquisitions. Such firms often find themselves targeted for takeover by other firms that propose to redeploy the cash for them. During the oil price slump of the early 1980s, many cash-rich oil companies found themselves threatened by takeover. This was not because their cash was a unique asset. The acquirers wanted to capture the companies’ cash flow to make sure it was not frittered away on negative-NPV oil exploration projects. We return to this free-cashflow motive for takeovers later in this chapter.

Eliminating Inefficiencies

Cash is not the only asset that can be wasted by poor management. There are always firms with unexploited opportunities to cut costs and increase sales and earnings. Such firms are natural candidates for acquisition by other firms with better management. In some instances, “better management” may simply mean the determination to force painful cuts or realign the company’s operations. Notice that the motive for such acquisitions has nothing to do with benefits from combining two firms. Acquisition is simply the mechanism by which a new management team replaces the old one.

A merger is not the only way to improve management, but sometimes it is the only simple and practical way. Managers are naturally reluctant to fire or demote themselves, and stockholders of large public firms do not usually have much direct influence on how the firm is run or who runs it.⁵

If this motive for merger is important, one would expect to observe that acquisitions often precede a change in the management of the target firm. This seems to be the case. For example, Martin and McConnell found that the chief executive is four times more likely to be replaced in the year after a takeover than during earlier years.⁶ The firms they studied had generally been poor performers; in the four years before acquisition their stock prices had lagged behind those of other firms in the same industry by 15%. Apparently many of these firms fell on bad times and were rescued, or reformed, by merger.

Industry Consolidation

The biggest opportunities to improve efficiency seem to come in industries with too many firms and too much capacity. These conditions can trigger a wave of mergers and acquisitions, which then force companies to cut capacity and employment and release capital for reinvestment elsewhere in the economy. For example, when U.S. defense budgets fell after the end of the Cold War, a round of consolidating takeovers followed in the defense industry. The consolidation was inevitable, but the takeovers accelerated it.

The banking industry is another example. During the financial crisis many banking mergers involved rescues of failing banks by larger and stronger rivals. But most earlier bank mergers involved successful banks that sought to achieve economies of scale. The United States entered the 1980s with far too many banks, largely as a result of outdated restrictions on interstate banking. As these restrictions eroded and communications and technology improved, small banks were swept up into regional or “super-regional” banks, and the number of banks declined from over 14,000 to little more than 5,000. For example, look at Figure 31.2, which shows some of the acquisitions by Bank of America and its predecessor companies. The main motive for these mergers was to reduce costs.⁷

FIGURE 31.2 Part of Bank of America’s family tree

Sources: Thomson Financial SDC M&A Database and Bank of America annual reports.

Europe also experienced a wave of bank mergers as companies sought to gain the financial muscle to compete in a Europe-wide banking market. These include the mergers of UBS and Swiss Bank Corp (1997), BNP and Banque Paribas (1998), Hypobank and Bayerische Vereinsbank (1998), Banco Santander and Banco Central Hispanico (1999), Unicredit and Capitalia (2007), and Commerzbank and Dresdner Bank (2009).

31-2Some Dubious Reasons for Mergers

The benefits that we have described so far all make economic sense. Other arguments sometimes given for mergers are dubious. Here are a few of the dubious ones.

Diversification

We have suggested that the managers of a cash-rich company may prefer to see it use that cash for acquisitions rather than distribute it as extra dividends. That is why we often see cash-rich firms in stagnant industries merging their way into fresh woods and pastures new.

What about diversification as an end in itself? It is obvious that diversification reduces risk. Isn’t that a gain from merging?

The trouble with this argument is that diversification is easier and cheaper for the stockholder than for the corporation. There is little evidence that investors pay a premium for diversified firms; in fact, as we will explain in Chapter 32, discounts are more common. The Appendix to this chapter provides a simple proof that corporate diversification does not increase value in perfect markets as long as investors’ diversification opportunities are unrestricted. This is the value-additivity principle introduced in Chapter 7.

Increasing Earnings per Share: The Bootstrap Game

Some acquisitions that offer no evident economic gains nevertheless produce several years of rising earnings per share. To see how this can happen, let us look at the acquisition of Muck and Slurry by the well-known conglomerate World Enterprises.

The position before the merger is set out in the first two columns of Table 31.2. Because Muck and Slurry has relatively poor growth prospects, its stock’s price–earnings ratio is lower than World Enterprises’ (line 3). The merger, we assume, produces no economic benefits, and so the firms should be worth exactly the same together as they are apart. The market value of World Enterprises after the merger should be equal to the sum of the separate values of the two firms (line 6).

	World Enterprises before Merger	Muck and Slurry	World Enterprises after Merger
1. Earnings per share	$2.00	$2.00	$2.67
2. Price per share	$40	$20	$40
3. Price–earnings ratio	20	10	15
4. Number of shares	100,000	100,000	150,000
5. Total earnings	$200,000	$200,000	$400,000
6. Total market value	$4,000,000	$2,000,000	$6,000,000
7. Current earnings per dollar invested in stock (line 1 ÷ line 2)	$0.05	$0.10	$0.067

TABLE 31.2 Impact of merger on market value and earnings per share of World Enterprises

Note: When World Enterprises purchases Muck and Slurry, there are no gains. Therefore, total earnings and total market value should be unaffected by the merger. But earnings per share increase. World Enterprises issues only 50,000 of its shares (priced at $40) to acquire the 100,000 Muck and Slurry shares (priced at $20).

Since World Enterprises’ stock is selling for double the price of Muck and Slurry stock (line 2), World Enterprises can acquire the 100,000 Muck and Slurry shares for 50,000 of its own shares. Thus, World will have 150,000 shares outstanding after the merger.

Total earnings double as a result of the merger (line 5), but the number of shares increases by only 50%. Earnings per share rise from $2.00 to $2.67. We call this the bootstrap effect because there is no real gain created by the merger and no increase in the two firms’ combined value. Since the stock price is unchanged, the price–earnings ratio falls (line 3).

Figure 31.3 illustrates what is going on here. Before the merger $1 invested in World Enterprises bought 5 cents of current earnings and rapid growth prospects. On the other hand, $1 invested in Muck and Slurry bought 10 cents of current earnings but slower growth prospects. If the total market value is not altered by the merger, then $1 invested in the merged firm gives 6.7 cents of immediate earnings but slower growth than World Enterprises offered alone. Muck and Slurry shareholders get lower immediate earnings but faster growth. Neither side gains or loses provided everybody understands the deal.

FIGURE 31.3 Effects of merger on earnings growth. By merging with Muck and Slurry, World Enterprises increases current earnings but accepts a slower rate of future growth. Its stockholders should be no better or worse off unless investors are fooled by the bootstrap effect.

Source: S. C. Myers, “A Framework for Evaluating Mergers,” in Modern Developments in Financial Management, ed. S. C. Myers (New York: Frederick A. Praeger, Inc., 1976), Figure 1, p. 639. Copyright © 1976 Praeger.

Financial manipulators sometimes try to ensure that the market does not understand the deal. Suppose that investors are fooled by the exuberance of the president of World Enterprises and by plans to introduce modern management techniques into its new Earth Sciences Division (formerly known as Muck and Slurry). They could easily mistake the 33% postmerger increase in earnings per share for real growth. If they do, the price of World Enterprises stock rises and the shareholders of both companies receive something for nothing.

This is a “bootstrap” or “chain letter” game. It generates earnings growth not from capital investment or improved profitability, but from purchase of slowly growing firms with low price–earnings ratios. If this fools investors, the financial manager may be able to puff up stock price artificially. But to keep fooling investors, the firm has to continue to expand by merger at the same compound rate. Clearly, this cannot go on forever; one day, expansion must slow down or stop. At this point, earnings growth falls dramatically and the house of cards collapses.

This game is not often played these days, but you may still encounter managers who would rather acquire firms with low price–earnings ratios. Beware of false prophets who suggest that you can appraise mergers just by looking at their immediate impact on earnings per share.

Lower Financing Costs

You often hear it said that a merged firm is able to borrow more cheaply than its separate units could. In part this is true. We have already seen (in Section 15-4) that there are economies of scale in making new issues. Therefore, if firms can make fewer, larger security issues by merging, there are genuine savings.

But when people say that borrowing costs are lower for the merged firm, they usually mean something more than lower issue costs. They mean that when two firms merge, the combined company can borrow at lower interest rates than either firm could separately. This, of course, is exactly what we should expect in a well-functioning bond market. While the two firms are separate, they do not guarantee each other’s debt; if one fails, the bondholder cannot ask the other for money. But after the merger, each enterprise effectively does guarantee the other’s debt; if one part of the business fails, the bondholders can still take their money out of the other part. Because these mutual guarantees make the debt less risky, lenders demand a lower interest rate.

Does the lower interest rate mean a net gain to the merger? Not necessarily. Compare the following two situations:

· Separate issues. Firm A and firm B each make a $50 million bond issue.

· Single issue. Firms A and B merge, and the new firm AB makes a single $100 million issue.

Of course AB would pay a lower interest rate, other things being equal. But it does not make sense for A and B to merge just to get that lower rate. Although AB’s shareholders do gain from the lower rate, they lose by having to guarantee each other’s debt. In other words, they get the lower interest rate only by giving bondholders better protection. There is no net gain.

In Section 23-2, we showed that

A merger of A and B increases bond value (or reduces the interest payments necessary to support a given bond value) only by reducing the value of stockholders’ option to default. In other words, the value of the default option for AB’s $100 million issue is less than the combined value of the two default options on A’s and B’s separate $50 million issues.

Now suppose that A and B each borrow $50 million and then merge. If the merger is a surprise, it is likely to be a happy one for the bondholders. The bonds they thought were guaranteed by one of the two firms end up guaranteed by both. The stockholders lose in this case because they have given bondholders better protection but have received nothing in exchange.

There is one situation in which mergers can create value by making debt safer. Consider a firm that covets interest tax shields but is reluctant to borrow more because of worries about financial distress. (This is the trade-off theory described in Chapter 18.) Merging decreases the probability of financial distress, other things equal. If it allows increased borrowing, and increased value from the interest tax shields, there can be a net gain to the merger.⁸

31-3Estimating Merger Gains and Costs

Suppose that you are the financial manager of firm A and you want to analyze the possible purchase of firm B. The first thing to think about is whether there is an economic gain from the merger. There is an economic gain only if the two firms are worth more together than apart. For example, if you think that the combined firm would be worth PV_AB and that the separate firms are worth PV_A and PV_B, then

Gain = PV_AB − ( PV_A + PV_B) = ΔPV_AB

If this gain is positive, there is an economic justification for merger. But you also have to think about the cost of acquiring firm B. Take the easy case in which payment is made in cash. Then the cost of acquiring B is equal to the cash payment minus B’s value as a separate entity. Thus,

Cost = cash paid − PV_B

The net present value to A of a merger with B is measured by the difference between the gain and the cost. Therefore, you should go ahead with the merger if its net present value, defined as

is positive.

We like to write the merger criterion in this way because it focuses attention on two distinct questions. When you estimate the benefit, you concentrate on whether there are any gains to be made from the merger. When you estimate cost, you are concerned with the division of these gains between the two companies.

An example may help make this clear. Firm A has a value of $200 million, and B has a value of $50 million. Merging the two would allow cost savings with a present value of $25 million. This is the gain from the merger. Thus,

Suppose that B is bought for cash—say, for $65 million. The cost of the merger is

Note that the stockholders of firm B—the people on the other side of the transaction—are ahead by $15 million. Their gain is your cost. They have captured $15 million of the $25 million merger gain. Thus when we write down the NPV of the merger from A’s viewpoint, we are really calculating the part of the gain that A’s stockholders get to keep. The NPV to A’s stockholders equals the overall gain from the merger less that part of the gain captured by B’s stockholders:

NPV = 25 − 15 = +$10 million

Just as a check, let’s confirm that A’s stockholders really come out $10 million ahead. They start with a firm worth PV_A = $200 million. They end up with a firm worth $275 million and then have to pay out $65 million to B’s stockholders.⁹ Thus their net gain is

Suppose investors do not anticipate the merger between A and B. The announcement will cause the value of B’s stock to rise from $50 million to $65 million, a 30% increase. If investors share management’s assessment of the merger gains, the market value of A’s stock will increase by $10 million, only a 5% increase.

It makes sense to keep an eye on what investors think the gains from merging are. If A’s stock price falls when the deal is announced, then investors are sending the message that the merger benefits are doubtful or that A is paying too much for them.

Right and Wrong Ways to Estimate the Benefits of Mergers

Some companies begin their merger analyses with a forecast of the target firm’s future cash flows. Any revenue increases or cost reductions attributable to the merger are included in the forecasts, which are then discounted back to the present and compared with the purchase price:

This is a dangerous procedure. Even the brightest and best-trained analyst can make large errors in valuing a business. The estimated net gain may come up positive not because the merger makes sense but simply because the analyst’s cash-flow forecasts are too optimistic. On the other hand, a good merger may not be pursued if the analyst fails to recognize the target’s potential as a stand-alone business.

Our procedure starts with the target’s stand-alone market value (PV_B) and concentrates on the changes in cash flow that would result from the merger. Ask yourself why the two firms should be worth more together than apart.

The same advice holds when you are contemplating the sale of part of your business. There is no point in saying to yourself, “This is an unprofitable business and should be sold.” Unless the buyer can run the business better than you can, the price you receive will reflect the poor prospects.

Sometimes you may come across managers who believe that there are simple rules for identifying good acquisitions. They may say, for example, that they always try to buy into growth industries or that they have a policy of acquiring companies that are selling below book value. But our comments in Chapter 11 about the characteristics of a good investment decision also hold true when you are buying a whole company. You add value only if you can generate additional economic rents—some competitive edge that other firms can’t match and the target firm’s managers can’t achieve on their own.

One final piece of horse sense: Often, two companies bid against each other to acquire the same target firm. In effect, the target firm puts itself up for auction. In such cases, ask yourself whether the target is worth more to you than to the other bidder. If the answer is no, you should be cautious about getting into a bidding contest. Winning such a contest may be more expensive than losing it. If you lose, you have simply wasted your time; if you win, you have probably paid too much.

More on Estimating Costs—What If the Target’s Stock Price Anticipates the Merger?

The cost of a merger is the premium that the buyer pays over the seller’s stand-alone value. How can that value be determined? If the target is a public company, you can start with its market value; just observe price per share and multiply by the number of shares outstanding. But bear in mind that if investors expect A to acquire B, or if they expect somebody to acquire B, the market value of B may overstate its stand-alone value.

This is one of the few places in this book where we draw an important distinction between market value (MV) and the true, or “intrinsic,” value (PV) of the firm as a separate entity. The problem here is not that the market value of B is wrong but that it may not be the value of firm B as a separate entity. Potential investors in B’s stock will see two possible outcomes and two possible values:

Outcome	Market Value of B’s Stock
1. No merger	PVB: Value of B as a separate firm
2. Merger occurs	PVB plus some part of the benefits of the merger

If the second outcome is possible, MV_B, the stock market value we observe for B, will overstate PV_B. This is exactly what should happen in a competitive capital market. Unfortunately, it complicates the task of a financial manager who is evaluating a merger.

Here is an example: Suppose that just before A and B’s merger announcement we observe the following:

	Firm A	Firm B
Market price per share	$200	$100
Number of shares	1,000,000	500,000
Market value of firm	$200 million	$50 million

Firm A intends to pay $65 million cash for B. If B’s market price reflects only its value as a separate entity, then

However, suppose that B’s share price has already risen by $12 because of rumors that B might get a favorable merger offer. That means that its intrinsic value is overstated by 12 × 500,000 = $6 million. Its true value, PV_B, is only $44 million. Then

Cost = (65 − 44) = $21 million

Since the merger gain is $25 million, this deal still makes A’s stockholders better off, but B’s stockholders are now capturing the lion’s share of the gain.

Notice that if the market made a mistake, and the market value of B was less than B’s true value as a separate entity, the cost could be negative. In other words, B would be a bargain and the merger would be worthwhile from A’s point of view, even if the two firms were worth no more together than apart. Of course, A’s stockholders’ gain would be B’s stockholders’ loss because B would be sold for less than its true value.

Firms have made acquisitions just because their managers believed they had spotted a company whose intrinsic value was not fully appreciated by the stock market. However, we know from the evidence on market efficiency that “cheap” stocks often turn out to be expensive. It is not easy for outsiders, whether investors or managers, to find firms that are truly undervalued by the market. Moreover, if the shares are really bargain-priced, A doesn’t need a merger to profit by its special knowledge. It can just buy up B’s shares on the open market and hold them passively, waiting for other investors to wake up to B’s true value.

If firm A is wise, it will not go ahead with a merger if the cost exceeds the gain. Firm B will not consent if A’s gain is so big that B loses. This gives us a range of possible cash payments that would allow the merger to take place. Whether the payment is at the top or the bottom of this range depends on the relative bargaining power of the two participants.

Estimating Cost When the Merger Is Financed by Stock

Many mergers involve payment wholly or partly in the form of the acquirer’s stock. When a merger is financed by stock, cost depends on the value of the shares in the new company received by the shareholders of the selling company. If the sellers receive N shares, each worth P_AB, the cost is

Cost = N × P_AB − PV_B

Just be sure to use the price per share after the merger is announced and its benefits are appreciated by investors.

Suppose that A offers 325,000 (.325 million) shares instead of $65 million in cash. A’s share price before the deal is announced is $200. If B is worth $50 million stand-alone,¹⁰ the cost of the merger appears to be

Apparent cost = .325 × 200 − 50 = $15 million

However, the apparent cost may not be the true cost. A’s stock price is $200 before the merger announcement. At the announcement it ought to go up.

Given the gain and the terms of the deal, we can calculate share prices and market values after the deal. The new firm will have 1.325 million shares outstanding and will be worth $275 million.¹¹ The new share price is 275/1.325 = $207.55. The true cost is

Cost = .325 × 207.55 − 50 = $17.45 million

This cost can also be calculated by figuring out the gain to B’s shareholders. They end up with .325 million shares, or 24.5% of the new firm AB. Their gain is

.245(275) − 50 = $17.45 million

In general, if B’s shareholders are given the fraction x of the combined firms,

Cost = x PV_AB − PV_B

We can now understand the first key distinction between cash and stock as financing instruments. If cash is offered, the cost of the merger is unaffected by the merger gains. If stock is offered, the cost depends on the gains because the gains show up in the postmerger share price.

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Stock financing mitigates the effect of overvaluation or undervaluation of either firm. Suppose, for example, that A overestimates B’s value as a separate entity, perhaps because it has overlooked some hidden liability. Thus, A makes too generous an offer. Other things being equal, A’s stockholders are better off if it is a stock offer rather than a cash offer. With a stock offer, the inevitable bad news about B’s value will fall partly on the shoulders of B’s stockholders.

Asymmetric Information

There is a second key difference between cash and stock financing for mergers. A’s managers will usually have access to information about A’s prospects that is not available to outsiders. Economists call this asymmetric information.

Suppose A’s managers are more optimistic than outside investors. They may think that A’s shares will really be worth $215 after the merger, $7.45 higher than the $207.55 market price we just calculated. If they are right, the true cost of a stock-financed merger with B is

Cost = .325 × 215 − 50 = $19.88

B’s shareholders would get a “free gift” of $7.45 for every A share they receive—an extra gain of $7.45 × .325 = 2.42, that is, $2.42 million.

Of course, if A’s managers were really this optimistic, they would strongly prefer to finance the merger with cash. Financing with stock would be favored by pessimistic managers who think their company’s shares are overvalued.

Does this sound like “win-win” for A—just issue shares when overvalued, cash otherwise? No, it’s not that easy, because B’s shareholders, and outside investors generally, understand what’s going on. Suppose you are negotiating on behalf of B. You find that A’s managers keep suggesting stock rather than cash financing. You quickly infer that A’s managers are pessimistic, mark down your own opinion of what the shares are worth, and drive a harder bargain.

This asymmetric-information story explains why the share prices of buying firms generally fall when stock-financed mergers are announced.¹² Andrade, Mitchell, and Stafford found an average market-adjusted fall of 1.5% on the announcement of stock-financed mergers between 1973 and 1998. There was a small gain (.4%) for a sample of cash-financed deals.¹³

31-4The Mechanics of a Merger

Buying a company is a much more complicated affair than buying a piece of machinery. Thus we should look at some of the problems encountered in arranging mergers. In practice, these arrangements are often extremely complex, and specialists must be consulted. We are not trying to replace those specialists; we simply want to alert you to the kinds of legal, tax, and accounting issues that they deal with.

Mergers, Antitrust Law, and Popular Opposition

Mergers can get bogged down in the federal antitrust laws. The most important statute here is the Clayton Act of 1914, which forbids an acquisition whenever “in any line of commerce or in any section of the country” the effect “may be substantially to lessen competition, or to tend to create a monopoly.”

Antitrust law can be enforced by the federal government in either of two ways: by a civil suit brought by the Justice Department or by a proceeding initiated by the Federal Trade Commission (FTC).¹⁴ The Hart–Scott–Rodino Antitrust Act of 1976 requires that these agencies be informed of all acquisitions of stock greater than about $75 million. Thus, almost all large mergers are reviewed at an early stage.¹⁵ Both the Justice Department and the FTC then have the right to seek injunctions delaying a merger. An injunction is often enough to scupper the companies’ plans. For example, when Halliburton proposed a $28 billion acquisition of Baker Hughes in 2014, the Justice Department filed a lawsuit to block the merger. The companies tried to deal with the Department’s objections by selling off various business lines to other players. But by 2016 it had become obvious that they could not assuage concerns that the merger would create too much market power, and the companies scrapped their merger plan.

Companies that do business outside the United States also have to worry about foreign antitrust laws. For example, GE’s $46 billion takeover bid for Honeywell was blocked by the European Commission, which argued that the combined company would have too much power in the aircraft industry.

Sometimes trustbusters will object to a merger, but then relent if the companies agree to divest certain assets and operations. For example, when Dow Chemical and DuPont announced plans to merge, the Justice Department required the companies to sell parts of their crop-protection business and two petrochemical plants.

Mergers may also be stymied by political pressures and popular resentment even when no formal antitrust issues arise. In recent years national governments in Europe have become involved in almost all high-profile cross-border mergers and are likely to intervene actively in any hostile bid. For example, the news in 2005 that PepsiCo might bid for Danone aroused considerable hostility in France. The prime minister added his support to opponents of the merger and announced that the French government was drawing up a list of strategic industries that should be protected from foreign ownership. It was unclear whether yogurt production would be one of these strategic industries.

Economic nationalism is not confined to Europe. In 2006, Congress voiced its opposition to the takeover of Britain’s P&O by the Dubai company DP World. The acquisition went ahead only after P&O’s ports in the United States were excluded from the deal. In 2018, the United States blocked Singapore-based Broadcom’s takeover bid for the U.S. chipmaker Qualcom. The U.S. government cited “national security concerns” about giving a foreign entity access to U.S. technology.

The Form of Acquisition

Suppose you are confident that the purchase of company B will not be challenged on antitrust grounds. Next you will want to consider the form of the acquisition.

One possibility is literally to merge the two companies, in which case one company automatically assumes all the assets and all the liabilities of the other. Such a merger must have the approval of at least 50% of the stockholders of each firm.¹⁶

An alternative is simply to buy the seller’s stock in exchange for cash, shares, or other securities. In this case the buyer can deal individually with the shareholders of the selling company. The seller’s managers may not be involved at all. Their approval and cooperation are generally sought, but if they resist, the buyer will attempt to acquire an effective majority of the outstanding shares. If successful, the buyer has control and can complete the merger and, if necessary, toss out the incumbent management.

The third approach is to buy some or all of the seller’s assets. In this case, ownership of the assets needs to be transferred, and payment is made to the selling firm rather than directly to its stockholders.

Merger Accounting

When one company buys another, its management worries about how the purchase will show up in its financial statements. Before 2001, the company had a choice of accounting method, but in that year, the Financial Accounting Standards Board (FASB) introduced new rules that required the buyer to use the purchase method of merger accounting. This is illustrated in Table 31.3, which shows what happens when A Corporation buys B Corporation, leading to the new AB Corporation. The two firms’ initial balance sheets are shown at the top of the table. Below this we show what happens to the balance sheet when the two firms merge. We assume that B Corporation has been purchased for $18 million, 180% of book value.

TABLE 31.3 Accounting for the merger of A Corporation and B Corporation assuming that A Corporation pays $18 million for B Corporation (figures in $ millions)

Key: NWC = net working capital; FA = net book value of fixed assets; D = debt; E = book value of equity.

Why did A Corporation pay an $8 million premium over B’s book value? There are two possible reasons. First, the true values of B’s tangible assets—its working capital, plant, and equipment—may be greater than $10 million. We will assume that this is not the reason; that is, we assume that the assets listed on its balance sheet are valued there correctly.¹⁷ Second, A Corporation may be paying for an intangible asset that is not listed on B Corporation’s balance sheet. For example, the intangible asset may be a promising product or technology. Or it may be no more than B Corporation’s share of the expected economic gains from the merger.

A Corporation is buying an asset worth $18 million. The problem is to show that asset on the left-hand side of AB Corporation’s balance sheet. B Corporation’s tangible assets are worth only $10 million. This leaves $8 million. Under the purchase method, the accountant takes care of this by creating a new asset category called goodwill and assigning $8 million to it.¹⁸ As long as the goodwill continues to be worth at least $8 million, it stays on the balance sheet and the company’s earnings are unaffected.¹⁹ However, the company is obliged each year to estimate the fair value of the goodwill. If the estimated value ever falls below $8 million, the goodwill is “impaired” and the amount shown on the balance sheet must be adjusted downward and the write-off deducted from that year’s earnings. Some companies have found that this can make a nasty dent in profits. For example, when the new accounting rules were introduced, AOL was obliged to write down the value of its assets by $54 billion.

Some Tax Considerations

An acquisition may be either taxable or tax-free. If payment is in the form of cash, the acquisition is regarded as taxable. In this case the selling stockholders are treated as having sold their shares, and they must pay tax on any capital gains. If payment is largely in the form of shares, the acquisition is tax-free and the shareholders are viewed as exchanging their old shares for similar new ones; no capital gains or losses are recognized.

The tax status of the acquisition also affects the taxes paid by the merged firm afterward. After a tax-free acquisition, the merged firm is taxed as if the two firms had always been together. In a taxable acquisition, the assets of the selling firm are revalued, the resulting write-up or write-down is treated as a taxable gain or loss, and tax depreciation is recalculated on the basis of the restated asset values.

A very simple example will illustrate these distinctions. In 2008, Captain B forms Sea-corp, which purchases a fishing boat for $300,000. Assume, for simplicity, that the boat is depreciated for tax purposes over 20 years on a straight-line basis (no salvage value). Thus, annual depreciation is $300,000/20 = $15,000, and in 2018, the boat has a net book value of $150,000. But Captain B finds that, owing to careful maintenance, inflation, and good times in the local fishing industry, the boat is really worth $280,000. In addition, Seacorp holds $50,000 of marketable securities.

Now suppose that Captain B sells the firm to Baycorp for $330,000. The possible tax consequences of the acquisition are shown in Table 31.4. In this case, Captain B may ask for a tax-free deal to defer capital gains tax. But Baycorp can afford to pay more in a taxable deal because depreciation tax shields are larger.

	Taxable Merger	Tax-Free Merger
Impact on Captain B	Captain B must recognize a $30,000 capital gain.	Capital gain can be deferred until Captain B sells the Baycorp shares.
Impact on Baycorp	Boat is revalued at $280,000. Tax depreciation increases to $280,000/10 = $28,000 per year (assuming 10 years of remaining life).	Boat’s value remains at $150,000, and tax depreciation continues at $15,000 per year.

TABLE 31.4 Possible tax consequences when Baycorp buys Seacorp for $330,000. Captain B’s original investment in Seacorp was $300,000. Just before the merger Seacorp’s assets were $50,000 of marketable securities and one boat with a book value of $150,000 but a market value of $280,000.

Cross-Border Mergers and Tax Inversion

In 2013, the U.S pharmaceutical company Actavis took over Warner-Chilcott of Ireland. As part of the deal, the company announced that it would reincorporate in Ireland, where the corporate tax rate is 12.5%–much lower than the combined U.S. federal and state corporate tax rate at that time. One year later, the company acquired Forest Labs, which, as a result, also changed its headquarters to Ireland.

Both deals were examples of tax inversion. Before 2018, the United States taxed profits of U.S. corporations even if the profits were earned overseas.²⁰ Other countries had a territorial system and taxed only profits that were earned domestically. Therefore, when a U.S. corporation relocated abroad because of a merger, it still needed to pay U.S. tax on its U.S. profits, but it no longer paid U.S. tax on profits earned elsewhere. Since the corporate tax rate in the United States was much higher than in most other developed countries, there was a strong incentive for U.S. companies to move their domicile abroad. One way to do this was to arrange to be acquired by a foreign company.

Starting in 2018, the United States switched over to a territorial tax system. As a result, tax is paid on income earned in the United States but not on overseas income. Therefore, the incentive to change the company’s domicile by merger has disappeared.²¹

31-5Proxy Fights, Takeovers, and the Market for Corporate Control

The shareholders are the owners of the firm. But most shareholders do not feel like the boss, and with good reason. Try buying one share of IBM stock and marching into the boardroom for a chat with your employee, the CEO. (However, if you own 50 million IBM shares, the CEO will travel to see you.)

The ownership and management of large corporations are separated. Shareholders elect the board of directors but have little direct say in most management decisions. Agency costs arise when managers or directors are tempted to make decisions that are not in the shareholders’ interests.

As we pointed out in Chapter 1, there are many forces and constraints working to keep managers’ and shareholders’ interests in line. But what can be done to ensure that the board has engaged the most talented managers? What happens if managers are inadequate? What if the board is derelict in monitoring the performance of managers? Or what if the firm’s managers are fine but the resources of the firm could be used more efficiently by merging with another firm? Can we count on managers to pursue policies that might put them out of a job?

These are all questions about the market for corporate control, the mechanisms by which firms are matched up with owners and management teams who can make the most of the firm’s resources. You should not take a firm’s current ownership and management for granted. If it is possible for the value of the firm to be enhanced by changing management or by reorganizing under new owners, there will be incentives for someone to make the change.

There are three ways to change the management of a firm: (1) a successful proxy contest in which a group of shareholders votes in a new board of directors who then pick a new management team, (2) a takeover of one company by another, and (3) a leveraged buyout of the firm by a private group of investors. We focus here on the first two methods and postpone discussion of buyouts until the next chapter.

Proxy Contests

Shareholders elect the board of directors to keep watch on management and replace unsatisfactory managers. If the board is lax, shareholders are free to elect a different board.

When a group of investors believes that the board and its management should be replaced, they can launch a proxy contest at the next annual meeting. A proxy is the right to vote another shareholder’s shares. In a proxy contest, the dissident shareholders attempt to obtain enough proxies to elect their own slate to the board of directors. Once the new board is in control, management can be replaced and company policy changed. A proxy fight is therefore a direct contest for control of the corporation. Many proxy fights are initiated by major shareholders who consider the firm poorly managed. In other cases a fight may be a prelude to the merger of two firms. The proponent of the merger may believe that a new board will better appreciate the advantages of combining the two firms.

Proxy contests are expensive and difficult to win. Dissidents who engage in proxy fights must use their own money, but management can use the corporation’s funds and lines of communications with shareholders to defend itself. To level the playing field somewhat, the SEC has introduced new rules to make it easier to mount a proxy fight.

Institutional shareholders, such as large hedge funds, have become more aggressive in pressing for managerial accountability and have been able to gain concessions by initiating proxy fights. For example, in 2017, hedge fund manager Nelson Peltz sought to persuade Procter & Gamble to make changes to its corporate structure and its brand policy. After failing to persuade management to offer him a board seat, he launched a proxy battle. The contest cost the two sides a reported $60 million and resulted in a victory for Peltz by a margin of .002%. Peltz believed that as a board member, he would be better placed to secure reforms.

Takeovers

The alternative to a proxy fight is for the would-be acquirer to make a tender offer directly to the shareholders. If the offer is successful, the new owner is free to make any management changes. The management of the target firm may advise its shareholders to accept the offer, or it may fight the bid in the hope that the acquirer will either raise its offer or throw in the towel.

In the United States, the rules for tender offers are set largely by the Williams Act of 1968 and by state laws. The Williams Act obliges firms that own 5% or more of another company’s shares to tip their hand by reporting their holding to the SEC and to outline their intentions in a Schedule 13(d) filing. This filing is often an invitation for other bidders to enter the fray and to force up the takeover premium. The consolation for the initial bidder is that if its bid is ultimately unsuccessful, it may be able to sell off its holding in the target at a substantial profit.

The courts act as a referee to see that contests are conducted fairly. The problem in setting these rules is that it is unclear who requires protection. Should the management of the target firm be given more weapons to defend itself against unwelcome predators? Or should it simply be encouraged to sit the game out? Or should it be obliged to conduct an auction to obtain the highest price for its shareholders?²² And what about would-be acquirers? Should they be forced to reveal their intentions at an early stage, or would that allow other firms to piggyback on their good ideas by entering bids of their own? Keep these questions in mind as we review a recent takeover battle.

Valeant Bids for Allergan

Allergan is a U.S. specialty pharmaceutical company, best known as the maker of Botox. In 2014, its independence was threatened by the Canadian firm, Valeant, which, in an unusual move, teamed up with the hedge fund, Pershing Square, to acquire Allergan. Between February and April 2014, Bill Ackman, the manager of Pershing, built up a holding of 9.7% of Allergan’s shares. Then on April 21, Valeant announced its offer for Allergan of $47 billion in a mixture of stock and cash, a premium of about 17% over Allergan’s previous day’s market value.

Allergan’s management rejected the offer as undervaluing the company. It accused Valeant of following a strategy of gobbling up acquisitions and starving them of funds. In turn, Valeant accused Allergan’s management of spending too freely on research and development and on sales and marketing. It promised that it would cut the combined company’s R&D spending by more than two-thirds.

As soon as Allergan became aware of Valeant’s offer, the board sought to protect itself by putting in place a poison pill. If any single shareholder acquired a holding of more than 10% of Allergan stock, the poison pill would allow Allergan to offer its other shareholders additional shares at a substantial discount. The immediate effect of Allergan’s pill was to stop Pershing from increasing its holding.

In May, Valeant moved to anticipate any antitrust objections to the merger by selling off the rights to some of its skin care products that competed with Allergan’s. It then raised its offer to $49.4 billion, and three days later, raised it again to $53 billion. Subsequently, in October, Valeant wrote to Allergan that it was prepared to raise its offer to at least $59 billion, though it stopped short of actually doing so.

As Allergan’s board continued to reject Valeant’s offers, Pershing proposed to call a special meeting of Allergan’s shareholders to replace the board with new members who would be more receptive to Valeant’s bid. Such a meeting would require the support of 25% of Allergan’s shareholders. Because the poison pill effectively grouped together any shareholders who acted jointly, Pershing needed to be sure that any demand for a special meeting would not trigger the poison pill. Whether Pershing would get the necessary support depended heavily on the response of arbitrageurs who owned at least 20% of Allergan’s shares.²³

In the end, Pershing did not need the support of Allergan’s shareholders for a special meeting. Allergan settled the pending litigation by agreeing to hold the meeting in December, giving Pershing the chance to attempt its threatened replacement of Allergan’s board.

But not everything was going well for Pershing and Valeant. In November 2014, a federal district court ruled that there were serious questions as to whether Pershing’s collaboration with Valeant involved insider trading and enjoined Pershing Square from voting its shares at Allergan’s special meeting unless it disclosed the facts underlying its exposure to liability for insider trading.

Although the poison pill could not prevent Pershing from calling the special meeting to unseat Allergan’s directors, it did give Allergan breathing space. So, while the parties were fighting their battles in the courts, Allergan started looking around for a more congenial partner. At first, it thought it had found one in Salix Pharmaceuticals. A combined company of Allergan and Salix would have been too large a fish for Valeant to swallow. Reports of the negotiations with Salix led Pershing to threaten that if Allergan went ahead with a bid for Salix, Pershing would immediately bring litigation against Allergan’s board for breach of fiduciary duty. But by then, Allergan had become disenchanted with the possible Salix merger. Shortly afterward, it found a more attractive partner in Actavis. In November 2014, Allergan agreed to a $66 billion offer from Actavis, and the long, acrimonious battle for Allergan was finally over.

Postscript: Allergan still continued to make the headlines. After the merger, Actavis sold off much of its existing business and changed its name to Allergan. In 2015, Allergan again found itself involved in a merger negotiation as the pharmaceutical giant Pfizer launched, but subsequently withdrew, a friendly $160 billion bid for the company.

Valeant also stayed in the news, but it was not news that its shareholders wanted to hear. Its shares plummeted more than 90% after the company uncovered accounting irregularities, warned of a potential default on its $30 billion of debt, and revealed it was under investigation by the SEC.

Takeover Defenses

What are the lessons from the battle for Allergan? First, the example illustrates some of the strategies of modern merger warfare. Firms such as Allergan that are worried about being taken over usually prepare their defenses in advance. Often they persuade shareholders to agree to shark-repellent changes to the corporate charter. For example, the charter may be amended to require that any merger must be approved by a supermajority of 80% of the shares rather than the normal 50%. Although shareholders are generally prepared to go along with management’s proposals, it is doubtful whether such shark-repellent defenses are truly in their interest. Managers who are protected from takeover appear to enjoy higher remuneration and to generate less wealth for their shareholders.²⁴

Many firms follow Allergan’s example and deter potential bidders by devising poison pills that make the company unappetizing. For example, the poison pill may give existing shareholders the right to buy the company’s shares at half price as soon as a bidder acquires more than 15% of the shares. The bidder is not entitled to the discount. Thus, the bidder resembles Tantalus—as soon as it has acquired 15% of the shares, control is lifted away from its reach. These and other lines of defense are summarized in Table 31.5.

Pre-Offer Defenses	Description
Shark-repellent charter amendments:
Staggered (or classified) board	The board is classified into three equal groups. Only one group is elected each year. Therefore, the bidder cannot gain control of the target immediately.
Supermajority	A high percentage of shares, typically 80%, is needed to approve a merger.
Fair price	Mergers are restricted unless a fair price (determined by formula or appraisal) is paid.
Restricted voting rights	Shareholders who acquire more than a specified proportion of the target have no voting rights unless approved by the target’s board.
Waiting period	Unwelcome acquirers must wait for a specified number of years before they can complete the merger.
Other:
Poison pill	Existing shareholders are issued rights that, if there is a significant purchase of shares by a bidder, can be used to purchase additional stock in the company at a bargain price.
Poison put	Existing bondholders can demand repayment if there is a change of control as a result of a hostile takeover.
Post-Offer Defenses
Litigation	Target files suit against bidder for violating antitrust or securities laws.
Asset restructuring	Target buys assets that bidder does not want or that will create an antitrust problem.
Liability restructuring	Target issues shares to a friendly third party, increases the number of shareholders, or repurchases shares from existing shareholders at a premium.

TABLE 31.5 A summary of takeover defenses

Why did Allergan’s management contest the takeover bid? One possible reason was to extract a higher price for the stock, for Valeant was twice led to raise its offer. But on other occasions the target’s management may reject a bid because it wishes to protect its position within the firm. Companies sometimes reduce these conflicts of interest by offering their managers golden parachutes—that is, generous payoffs if the managers lose their jobs as a result of a takeover. It may seem odd to reward managers for being taken over. However, if a soft landing overcomes their opposition to takeover bids, a few million may be a small price to pay.

Any management team that tries to develop improved weapons of defense must expect challenge in the courts. In the early 1980s, the courts tended to give managers the benefit of the doubt and respect their business judgment about whether a takeover should be resisted. But the courts’ attitudes to takeover battles have shifted. For example, in 1993 a court blocked Viacom’s agreed takeover of Paramount on the grounds that Paramount directors did not do their homework before turning down a higher offer from QVC. Paramount was forced to give up its poison-pill defense and the stock options that it had offered to Viacom. Such decisions have led managers to become more careful in opposing bids, and they do not throw themselves blindly into the arms of any white knight.

At the same time, companies have acquired some new defensive weapons. In 1987, the Supreme Court upheld state laws that allow companies to deprive an investor of voting rights as soon as the investor’s share in the company exceeds a certain level. Since then, state anti-takeover laws have proliferated. Many allow boards of directors to block mergers with hostile bidders for several years and to consider the interests of employees, customers, suppliers, and their communities in deciding whether to try to block a hostile bid.

Anglo-Saxon countries used to have a near-monopoly on hostile takeovers. That is no longer the case. Takeover activity in Europe often exceeds that in the United States, and in recent years, some of the most bitterly contested takeovers have involved European companies. For example, Mittal’s $27 billion takeover of Arcelor resulted from a fierce and highly politicized five-month battle. Arcelor used every defense in the book—including inviting a Russian company to become a leading shareholder.

Mittal is now based in Europe, but it began operations in Indonesia. This illustrates another change in the merger market. Acquirers are also no longer confined to the major industrialized countries. They now include Brazilian, Indian, and Chinese companies. For example, Tetley Tea, Anglo-Dutch steelmaker Corus, and Jaguar and Land Rover have all been acquired by Indian conglomerate Tata Group. In China, Lenovo acquired IBM’s personal computer business, Geely bought Volvo from Ford, and China National Chemical bought Syngenta, the Swiss agrichemical busines. In Brazil, Vale purchased Inco, the Canadian nickel producer, and Cutrale-Safra bought the U.S. banana company Chiquita Brands.

Who Gains Most in Mergers?

As our brief history illustrates, in mergers sellers generally do better than buyers. Why do sellers earn higher returns? There are two reasons. First, buying firms are typically larger than selling firms. In many mergers, the buyer is so much larger that even substantial net benefits would not show up clearly in the buyer’s share price. Suppose, for example, that company A buys company B, which is only one-tenth A’s size. Suppose the dollar value of the net gain from the merger is split equally between A and B.²⁵ Each company’s shareholders receive the same dollar profit, but B’s receive 10 times A’s percentage return.

The second, and more important, reason is the competition among potential bidders. Once the first bidder puts the target company “in play,” one or more additional suitors often jump in, sometimes as white knights at the invitation of the target firm’s management. Every time one suitor tops another’s bid, more of the merger gain slides toward the target. At the same time, the target firm’s management may mount various legal and financial counterattacks, ensuring that capitulation, if and when it comes, is at the highest attainable price.

Identifying attractive takeover candidates and mounting a bid are high-cost activities. So why should anyone incur these costs if other bidders are likely to jump in later and force up the takeover premium? Mounting a bid may be more worthwhile if a company can first accumulate a holding in the target company. The Williams Act allows a company to acquire a toehold of up to 5% of the target’s shares before it is obliged to reveal its holding and outline its plans. So, even if the bid is ultimately unsuccessful, the company may be able to sell off its holding in the target at a substantial profit.

Bidders and targets are not the only possible winners. Other winners include investment bankers, lawyers, accountants, and in some cases arbitrageurs such as hedge funds, which speculate on the likely success of takeover bids.²⁶ “Speculate” has a negative ring, but it can be a useful social service. A tender offer may present shareholders with a difficult decision. Should they accept, should they wait to see if someone else produces a better offer, or should they sell their stock in the market? This dilemma presents an opportunity for hedge funds, which specialize in answering such questions. In other words, they buy from the target’s shareholders and take on the risk that the deal will not go through.

31-6Merger Waves and Merger Profitability

Merger Waves

Look back at Figure 31.1, which shows the number of mergers in the United States for each year since 1985. Notice that mergers come in waves. There was an upsurge in merger activity from 1967 to 1969 and then again in the late 1980s and 1990s. Another merger boom got under way in 2003, petered out with the onset of the credit crisis, and resumed in 2013. These were generally periods of rising stock prices

We don’t really understand why merger activity is so volatile and why it seems to be associated with booming stockmarkets. If mergers are prompted by economic motives, at least one of these motives must be “here today and gone tomorrow,” and it must somehow be associated with high stock prices. But none of the economic motives that we review in this chapter has anything to do with the general level of the stock market. None burst on the scene in the 1960s, departed in 1970, and reappeared for most of the 1980s and again in the mid-1990s and early 2000s. Some mergers may result from mistakes in valuation on the part of the stock market. In other words, the buyer may believe that investors have underestimated the value of the seller or may hope that they will overestimate the value of the combined firm. But we see (with hindsight) that mistakes are made in bear markets as well as bull markets. Why don’t we see just as many firms hunting for bargain acquisitions when the stock market is low? It is possible that “suckers are born every minute,” but it is difficult to believe that they can be harvested only in bull markets.

Merger activity in each wave tends to be concentrated in a relatively small number of industries and is often prompted by deregulation. For example, deregulation of telecoms and banking in the 1990s led to a spate of mergers in both industries.²⁷ Changes in technology or the pattern of demand can also prompt a spate of mergers. For example, the reduction in defense expenditures following the end of the cold war led to a wave of consolidations among defense companies.

Merger Announcements and the Stock Price

Look back at Figure 13.3, which shows the performance of the stocks of U.S. target firms around the time of the merger announcement. On average, the announcement was associated with an abnormal return of 17.3% for the target shareholders. This is the premium that investors expected the acquirer would need to pay to consummate the merger. Of course, this is an average figure; selling shareholders sometimes obtained much higher returns. When Hewlett-Packard won its takeover battle to buy data-storage company 3Par, it paid a premium of 230% for 3Par’s stock.

Selling shareholders clearly do well from mergers. But what about shareholders of the acquiring firm? A similar picture to Figure 13.3 would show that they have roughly broken even in the weeks surrounding the bid. Perhaps the acquirers’ shareholders were unduly pessimistic about the merger, but there is no sign that they became more enthusiastic later.

Since the selling shareholders gain and the buyers roughly break-even, it looks as if on average the merging firms are worth more together than apart. For example, Andrade, Mitchell, and Stafford found that between 1973 and 1998, the overall value of merging U.S. firms, buyer and seller combined, increased by 1.8%. However, the gains are at best fairly small and accrue to the seller rather than the buyer.²⁸

Merger Profitability

Studies of the stock price reaction to merger announcements may show how investors expect mergers to work out. But can we say whether mergers do subsequently enhance profitability? The problem here is that we don’t know how companies would have fared if they had not merged. Ravenscroft and Scherer, who looked at mergers during the 1960s and early 1970s, argued that productivity declined in the years following a merger.²⁹ But studies of later merger activity suggest that mergers do seem to improve real productivity. For example, Paul Healy, Krishna Palepu, and Richard Ruback examined 50 large mergers between 1979 and 1983 and found an average increase of 2.4 percentage points in the companies’ pretax returns.³⁰ They argue that this gain came from generating a higher level of sales from the same assets. There was no evidence that the companies were mortgaging their long-term future by cutting back on long-term investments; expenditures on capital equipment and research and development tracked industry averages.³¹

Do Mergers Generate Net Benefits?

There are undoubtedly good acquisitions and bad acquisitions. But if, on average, mergers appear to break even for the buyer, why do we observe so much merger activity? Some believe that the explanation lies in behavioral traits. The managers of acquiring firms may be driven by hubris or overconfidence in their ability to run the target firm better than its existing management, so the acquirers pay too much. There is some evidence to support this view. For example, one study documents large losses to more aggressive acquirers in the merger wave of 1998–2001.³² Another study of closely fought takeover contests found that winners’ stock returns were 24% less than the losers’ over the three years post-merger.³³

Warren Buffet summarizes the situation as follows:

Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T[arget]. . . . We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses—even after their corporate backyards are knee-deep in unresponsive toads.³⁴

Why do so many firms make acquisitions that appear to destroy value? We have suggested that overconfidence may be an explanation, but we should also not dismiss more charitable explanations. For example, McCardle and Viswanathan have pointed out that firms can enter or expand in a product market either by building a new plant or by buying an existing business. If the market is shrinking, it makes more sense for the firm to expand by acquisition. Hence, when it announces the acquisition, firm value may drop simply because investors conclude that the product market is no longer growing. The acquisition in this case does not destroy value; it just signals the stagnant state of the market.³⁵

We have discussed the impact of mergers on the companies directly involved, but the most important effects may be felt by the managers of other companies. Since poorly performing firms are more likely to be targets, the threat of takeover may spur the whole of corporate America to try harder. Unfortunately, we don’t know whether, on balance, the threat of merger makes for active days or sleepless nights.

SUMMARY

A merger generates synergies—that is, added value—if the two firms are worth more together than apart. Suppose that firms A and B merge to form a new entity, AB. Then the gain from the merger is

Gain = PV_AB − (PV_A + PV_B ) = ΔPV_AB

Gains from mergers may reflect economies of scale, economies of vertical integration, improved efficiency, the combination of complementary resources, or redeployment of surplus funds. In some cases the object is to install a more efficient management team or to force shrinkage and consolidation in an industry with excess capacity or too many small, inefficient companies. There are also dubious reasons for mergers. There is no value added by merging just to diversify risks, to reduce borrowing costs, or to pump up earnings per share.

You should go ahead with the acquisition if the gain exceeds the cost. Cost is the premium that the buyer pays for the selling firm over its value as a separate entity. It is easy to estimate when the merger is financed by cash. In that case,

Cost = cash paid − PV_B

When payment is in the form of shares, the cost naturally depends on what those shares are worth after the merger is complete. If the merger is a success, B’s stockholders will share the merger gains.

The mechanics of buying a firm are much more complex than those of buying a machine. First, you have to make sure that the purchase does not fall afoul of the antitrust laws or other governmental constraints. Second, you have a choice of procedures: You can merge all the assets and liabilities of the seller into those of your own company; you can buy the stock of the seller rather than the company itself; or you can buy the individual assets of the seller. Third, you have to worry about the tax status of the merger.

Mergers are often amicably negotiated between the management and directors of the two companies; but if the seller is reluctant, the would-be buyer can decide to make a tender offer. We sketched some of the offensive and defensive tactics used in takeover battles. We also observed that when the target firm loses, its shareholders typically win: Selling shareholders earn large abnormal returns, while the bidding firm’s shareholders roughly break even. The typical merger appears to generate positive net benefits for investors, but competition among bidders, plus active defense by target management, pushes most or all of the gains toward the selling shareholders.

Mergers come and go in waves. Merger activity thrives in periods of economic expansion and buoyant stock prices. Mergers are most frequent in industries that are coping with change, for example, changes in technology or regulation. The wave of mergers in banking and telecoms, for instance, can be traced to deregulation of these industries in the 1990s.

FURTHER READING

Here are three general works on mergers:

R. Bruner, Applied Mergers and Acquisitions (Hoboken, NJ: John Wiley & Sons, 2004).

J. F. Weston, M. L. Mitchell, and J. H. Mulherin, Takeovers, Restructuring and Corporate Governance, 4th ed. (Upper Saddle River, NJ: Prentice-Hall, 2013).

S. Betton, B. E. Eckbo, and K. S. Thorburn, “Corporate Takeovers,” in B. E. Eckbo (ed.), Handbook of Empirical Corporate Finance (Amsterdam: Elsevier/North-Holland, 2007), Chapter 15.

Historical information about mergers is reviewed in:

G. Andrade, M. Mitchell, and E. Stafford, “New Evidence and Perspectives on Mergers,” Journal of Economic Perspectives 15 (Spring 2001), pp. 103–120.

S. J. Everett, “The Cross-Border Mergers and Acquisitions Wave of the Late 1990s,” in R. E. Baldwin and L. A. Winters (eds.), Challenges to Globalization (Chicago: University of Chicago Press, 2004).

J. Harford, “What Drives Merger Waves?” Journal of Financial Economics 77 (September 2005), pp. 529–560.

B. Holmstrom and S. N. Kaplan, “Corporate Governance and Merger Activity in the U.S.: Making Sense of the 1980s and 1990s,” Journal of Economic Perspectives 15 (Spring 2001), pp. 121–144.

Finally, here are some informative case studies:

S. N. Kaplan (ed.), Mergers and Productivity (Chicago: University of Chicago Press, 2000). This is a collection of case studies.

R. Bruner, “An Analysis of Value Destruction and Recovery in the Alliance and Proposed Merger of Volvo and Renault,” Journal of Financial Economics 51 (1999), pp. 125–166.

PROBLEM SETS

Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.

1. Mergers* True or false?

a. Sellers almost always gain in mergers.

b. Buyers usually gain more than sellers.

c. Firms that do unusually well tend to be acquisition targets.

d. Merger activity in the United States varies dramatically from year to year.

e. On the average, mergers produce large economic gains.

f. Tender offers require the approval of the selling firm’s management.

g. The cost of a merger to the buyer equals the gain realized by the seller.

2. Mergers True or false?

a. Under purchase accounting any difference between the amount paid for the target’s assets and their book value is shown as goodwill in the merged company’s balance sheet.

b. In a tax-free merger, the acquirer can write up the value of the target’s assets and deduct a higher depreciation charge.

c. If a company receives payment from the Internal Revenue Service, it is known as “tax inversion.”

d. Both the Justice Department and the FTC can seek injunctions to delay a merger where there may be anti-trust issues.

e. Stock financing for mergers mitigates the effect of over- or under-valuation of the target.

3. Merger types* Are the following hypothetical mergers horizontal, vertical, or conglomerate?

a. IBM acquires Dell Computer.

b. Dell Computer acquires Walmart.

c. Walmart acquires Tyson Foods.

d. Tyson Foods acquires IBM.

4. Merger motives Which of the following motives for mergers make economic sense?

a. Merging to achieve economies of scale.

b. Merging to reduce risk by diversification.

c. Merging to redeploy cash generated by a firm with ample profits but limited growth opportunities.

d. Merging to combine complementary resources.

e. Merging just to increase earnings per share.

5. Merger motives Examine several recent mergers and suggest the principal motives for merging in each case.

6. Merger motives Suppose you obtain special information—information unavailable to investors—indicating that Backwoods Chemical’s stock price is 40% undervalued. Is that a reason to launch a takeover bid for Backwoods? Explain carefully.

7. Merger motives Respond to the following comments.

a. “Our cost of debt is too darn high, but our banks won’t reduce interest rates as long as we’re stuck in this volatile widget-trading business. We’ve got to acquire other companies with safer income streams.”

b. “Merge with Fledgling Electronics? No way! Their P/E’s too high. That deal would knock 20% off our earnings per share.”

c. “Our stock’s at an all-time high. It’s time to make our offer for Digital Organics. Sure, we’ll have to offer a hefty premium to Digital stockholders, but we don’t have to pay in cash. We’ll give them new shares of our stock.”

8. Merger motives* The Muck and Slurry merger has fallen through (see Section 31-2). But World Enterprises is determined to report earnings per share of $2.67. It therefore acquires the Wheelrim and Axle Company. You are given the following facts:

	World Enterprises	Wheelrim and Axle	Merged Firm
Earnings per share	$2.00	$2.50	$2.67
Price per share	$40	$25	?
Price–earnings ratio	20	10	?
Number of shares	100,000	200,000	?
Total earnings	$200,000	$500,000	?
Total market value	$4,000,000	$5,000,000	?

9. Once again, there are no gains from merging. In exchange for Wheelrim and Axle shares, World Enterprises issues just enough of its own shares to ensure its $2.67 earnings per share objective.

a. Complete the table for the merged firm.

b. How many shares of World Enterprises are exchanged for each share of Wheelrim and Axle?

c. What is the cost of the merger to World Enterprises?

d. What is the change in the total market value of the World Enterprises shares that were outstanding before the merger?

10. Merger gains and costs Velcro Saddles is contemplating the acquisition of Skiers’ Airbags Inc. The values of the two companies as separate entities are $20 million and $10 million, respectively. Velcro Saddles estimates that by combining the two companies, it will reduce marketing and administrative costs by $500,000 per year in perpetuity. Velcro Saddles can either pay $14 million cash for Skiers’ or offer Skiers’ a 50% holding in Velcro Saddles. The opportunity cost of capital is 10%.

a. What is the gain from merger?

b. What is the cost of the cash offer?

c. What is the cost of the stock alternative?

d. What is the NPV of the acquisition under the cash offer?

e. What is its NPV under the stock offer?

11. Merger gains and costs As financial manager of Corton Inc., you are investigating a possible acquisition of Denham. You have the basic data given in the following table. You estimate that investors expect a steady growth of about 6% in Denham’s earnings and dividends. Under new management, this growth rate would be increased to 8% per year without the need for additional capital.

	Corton	Denham
Forecast earnings per share	$5.00	$1.50
Forecast dividend per share	$3.00	$0.80
Number of shares	1,000,000	600,000
Stock price	$90	$20

a. What is the gain from the acquisition?

b. What is the cost of the acquisition if Corton pays $25 in cash for each share of Denham?

c. What is the cost of the acquisition if Corton offers one share of Corton for every three shares of Denham?

d. How would the cost of the cash offer change if the expected growth rate of Corton was not changed by the merger?

e. How would the cost of the share offer change if the expected growth rate was not changed by the merger?

12. Merger gains and costs* Gobi Desserts is bidding to take over Universal Puddings. Gobi has 3,000 shares outstanding, selling at $50 per share. Universal has 2,000 shares outstanding, selling at $17.50 a share. Gobi estimates the economic gain from the merger to be $15,000.

a. If Universal can be acquired for $20 a share, what is the NPV of the merger to Gobi?

b. What will Gobi sell for when the market learns that it plans to acquire Universal for $20 a share?

c. What will Universal sell for?

d. What are the percentage gains to the shareholders of each firm?

e. Now suppose that the merger takes place through an exchange of stock. On the basis of the premerger prices of the firms, Gobi sells for $50, so instead of paying $20 cash, Gobi issues .40 of its shares for every Universal share acquired. What will be the stock price of the merged firm?

f. What is the NPV of the merger to Gobi when it uses an exchange of stock? Why does your answer differ from part (a)?

13. Merger gains and costs Winterbourne is considering a takeover of Monkton Inc. Winterbourne has 10 million shares outstanding, which sell for $40 each. Monkton has 5 million shares outstanding, which sell for $20 each. If the merger gains are estimated at $25 million, what is the highest price per share that Winterbourne should be willing to pay to Monkton shareholders?

14. Merger gains and costs If Winterbourne from Problem 12 has a price-earnings ratio of 12 and Monkton has a P/E ratio of 8, what should be the P/E ratio of the merged firm? Assume in this case that the merger is financed by an issue of new Winterbourne shares. Monkton will get one Winterbourne share for every two Monkton shares held. In the short run the merger has no effect on the earnings outlook for the two businesses.

15. Merger gains and costs Sometimes the stock price of a possible target company rises in anticipation of a merger bid. Explain how this complicates the bidder’s evaluation of the target company.

16. Merger gains and costs Examine a recent merger in which at least part of the payment made to the seller was in the form of stock. Use stock market prices to obtain an estimate of the gain from the merger and the cost of the merger.

17. Merger accounting Look again at Table 31.3. Suppose that B Corporation’s fixed assets are reexamined and found to be worth $12 million instead of $9 million. How would this affect the AB Corporation’s balance sheet under purchase accounting? How would the value of AB Corporation change? Would your answer depend on whether the merger is taxable?

18. Taxation Explain the distinction between a tax-free and a taxable merger. Are there circumstances in which you would expect buyer and seller to agree to a taxable merger?

19. Taxation Which of the following transactions are not likely to be classed as tax-free?

a. An acquisition of assets.

b. A merger in which payment is entirely in the form of voting stock.

20. Merger tactics* Connect each term to its correct definition or description.

a. poison pill

b. tender offer

c. shark repellent

d. merger

e. tax inversion

f. proxy contest

A. Changes in the corporate charter that are designed to deter an unwelcome takeover

B. Measure in which shareholders are issued rights to buy shares if the bidder acquires a large stake in the firm

C. Relocation of company domicile to low-tax country often by way of merger

D. Offer to buy shares directly from stockholders

E. One company assumes all the assets and all the liabilities of another

F. Attempt to gain control of a firm by winning the votes of its stockholders

21. Merger tactics In Section 31-5, we described how Valeant and its ally, Pershing Square, lost the battle to acquire Allergan. Sometimes, the losers in a takeover battle can also win if they own a toehold stake in the target’s stock. Between April and June 2014, Pershing acquired a 9.7% stake in Allergan at an estimated average price of $128 a share. In November, Actavis offered $219 per share for each of Allergan’s 299 million shares. What was Pershing’s profit on its holding?

CHALLENGE

21. Takeover tactics Examine a hostile acquisition and discuss the tactics employed by both the predator and the target companies. Do you think that the management of the target firm was trying to defeat the bid or to secure the highest price for its stockholders? How did each announcement by the protagonists affect their stock prices?

22. Merger regulation How do you think mergers should be regulated? For example, what defenses should target companies be allowed to employ? Should managers of target firms be compelled to seek out the highest bids? Should they simply be passive and watch from the sidelines?

APPENDIX

Conglomerate Mergers and Value Additivity

A pure conglomerate merger is one that has no effect on the operations or profitability of either firm. If corporate diversification is in stockholders’ interests, a conglomerate merger would give a clear demonstration of its benefits. But if present values add up, the conglomerate merger would not make stockholders better or worse off.

In this appendix, we examine more carefully our assertion that present values add. It turns out that values do add as long as capital markets are perfect and investors’ diversification opportunities are unrestricted.

Call the merging firms A and B. Value additivity implies

PV_AB = PV_A + PV_B

where

PV_AB = market value of combined firms just after merger

PV_A, PV_B = separate market values of A and B just before merger

For example, we might have

PV_A = $100 million ($200 per share × 500,000 shares outstanding)

and

PV_B = $200 million ($200 per share × 1,000,000 shares outstanding )

Suppose A and B are merged into a new firm, AB, with one share in AB exchanged for each share of A or B. Thus, there are 1,500,000 AB shares issued. If value additivity holds, then PV_AB

must equal the sum of the separate values of A and B just before the merger—that is, $300 million. That would imply a price of $200 per share of AB stock.

But note that the AB shares represent a portfolio of the assets of A and B. Before the merger, investors could have bought one share of A and two of B for $600. Afterward, they can obtain a claim on exactly the same real assets by buying three shares of AB.

Suppose that the opening price of AB shares just after the merger is $200, so that PV_AB = PV_A + PV_B. Our problem is to determine if this is an equilibrium price—that is, whether we can rule out excess demand or supply at this price.

For there to be excess demand, there must be some investors who are willing to increase their holdings of A and B as a consequence of the merger. Who could they be? The only thing new created by the merger is diversification, but those investors who want to hold assets of A and B will have purchased A’s and B’s stock before the merger. The diversification is redundant and consequently won’t attract new investment demand.

Is there a possibility of excess supply? The answer is yes. For example, there will be some shareholders in A who did not invest in B. After the merger they cannot invest solely in A, but only in a fixed combination of A and B. Their AB shares will be less attractive to them than the pure A shares, so they will sell part of or all their AB stock. In fact, the only AB shareholders who will not wish to sell are those who happened to hold A and B in exactly a 1:2 ratio in their premerger portfolios!

Since there is no possibility of excess demand but a definite possibility of excess supply, we seem to have

PV_AB ≤ PV_A + PV_B

That is, corporate diversification can’t help, but it may hurt investors by restricting the types of portfolios they can hold. This is not the whole story, however, since investment demand for AB shares might be attracted from other sources if PV_AB drops below PV_A + PV_B. To illustrate, suppose there are two other firms, A* and B*, which are judged by investors to have the same risk characteristics as A and B, respectively. Then before the merger,

r_A = r_A* and r_B = r_B*

where r is the rate of return expected by investors. We’ll assume r_A = r_A* = .08 and r_B = r_B* = .20.

Consider a portfolio invested one-third in A* and two-thirds in B*. This portfolio offers an expected return of 16%:

A similar portfolio of A and B before their merger also offered a 16% return.

As we have noted, a new firm AB is really a portfolio of firms A and B, with portfolio weights of ⅓ and ⅔. It is therefore equivalent in risk to the portfolio of A* and B*. Thus, the price of AB shares must adjust so that it likewise offers a 16% return.

What if AB shares drop below $200, so that PV_AB is less than PV_A + PV_B? Since the assets and earnings of firms A and B are the same, the price drop means that the expected rate of return on AB shares has risen above the return offered by the A*B* portfolio. That is, if r_AB exceeds ⅓r_A + ⅔r_B, then r_AB must also exceed ⅓r_A* + ⅔r_B*. But this is untenable: Investors A* and B* could sell part of their holdings (in a 1:2 ratio), buy AB, and obtain a higher expected rate of return with no increase in risk.

On the other hand, if PV_AB rises above PV_A + PV_B, the AB shares will offer an expected return less than that offered by the A*B* portfolio. Investors will unload the AB shares, forcing their price down.

A stable result occurs only if AB shares stick at $200. Thus, value additivity will hold exactly in a perfect-market equilibrium if there are ample substitutes for the A and B assets. If A and B have unique risk characteristics, however, then PV_AB can fall below PV_A + PV_B. The reason is that the merger curtails investors’ opportunity to tailor their portfolios to their own needs and preferences. This makes investors worse off, reducing the attractiveness of holding the shares of firm AB.

In general, the condition for value additivity is that investors’ opportunity set—that is, the range of risk characteristics attainable by investors through their portfolio choices—is independent of the particular portfolio of real assets held by the firm. Diversification per se can never expand the opportunity set given perfect security markets. Corporate diversification may reduce the investors’ opportunity set, but only if the real assets the corporations hold lack substitutes among traded securities or portfolios.

In rare cases, the firm may be able to expand the opportunity set. It can do so if it finds an investment opportunity that is unique—a real asset with risk characteristics shared by few or no other financial assets. In this lucky event, the firm should not diversify, however. It should set up the unique asset as a separate firm so as to expand investors’ opportunity set to the maximum extent. If Gallo by chance discovered that a small portion of its vineyards produced wine comparable to Chateau Margaux, it would not throw that wine into the Hearty Burgundy vat.

¹Bill Vlasic, and Bradley A Stertz., “Taken for a Ride,” BusinessWeek, June 5, 2000. Used with permission of Bloomberg L.P. ©2017. All rights reserved.

²See “Analysis of the Kraft-Heinz Merger,” Forbes, March 30, 2015.

³Economies of scale are enjoyed when the average unit cost of production goes down as production increases. One way to achieve economies of scale is to spread fixed costs over a larger volume of production.

⁴For example, in 2006 the European Commission challenged Philips’s proposed acquisition of Intermagnetics. However, Philips successfully argued that for some years, it had taken over 99% of Intermagnetics output and that the combination of the two companies would facilitate the development of new MRI systems.

⁵It is difficult to assemble a large-enough block of stockholders to effectively challenge management and the incumbent board of directors. Stockholders can have enormous indirect influence, however. Their displeasure shows up in the firm’s stock price. A low stock price may encourage a takeover bid by another firm.

⁶K. J. Martin and J. J. McConnell, “Corporate Performance, Corporate Takeovers, and Management Turnover,” Journal of Finance 46 (June 1991), pp. 671–687.

⁷A study of 41 large bank mergers calculated present values of cost savings averaging 12% of the combined market values of the merging banks. See. J. F. Houston, C. M. James, and M. D. Ryngaert, “Where Do Merger Gains Come From? Bank Mergers from the Perspective of Insiders and Outsiders,” Journal of Financial Economics 60 (May 2001), pp. 285–331.

⁸This merger rationale was first suggested by W. G. Lewellen, “A Pure Financial Rationale for the Conglomerate Merger,” Journal of Finance 26 (May 1971), pp. 521–537. If you want to see some of the controversy and discussion that this idea led to, look at R. C. Higgins and L. D. Schall, “Corporate Bankruptcy and Conglomerate Merger,” Journal of Finance 30 (March 1975), pp. 93–113; and D. Galai and R. W. Masulis, “The Option Pricing Model and the Risk Factor of Stock,” Journal of Financial Economics 3 (January–March 1976), especially pp. 66–69.

⁹We are assuming that PV_A includes enough cash to finance the deal, or that the cash can be borrowed at a market interest rate. Notice that the value to A’s stockholders after the deal is done and paid for is $275 − 65 = $210 million—a gain of $10 million.

¹⁰In this case, we assume that B’s stock price has not risen on merger rumors and accurately reflects B’s stand-alone value.

¹¹In this case, no cash is leaving the firm to finance the merger. In our example of a cash offer, $65 million would be paid out to B’s stockholders, leaving the final value of the firm at 275 − 65 = $210 million. There would only be one million shares outstanding, so share price would be $210. The cash deal is better for A’s shareholders in this example.

¹²The same reasoning applies to stock issues. See Sections 15-4 and 18-4.

¹³See G. Andrade, M. Mitchell, and E. Stafford, “New Evidence and Perspectives on Mergers,” Journal of Economic Perspectives 15 (Spring 2001), pp. 103–120. This result confirms earlier work, including N. Travlos, “Corporate Takeover Bids, Methods of Payment, and Bidding Firms’ Stock Returns,” Journal of Finance 42 (September 1987), pp. 943–963; and J. R. Franks, R. S. Harris, and S. Titman, “The Postmerger Share-Price Performance of Acquiring Firms,” Journal of Financial Economics 29 (March 1991), pp. 81–96.

¹⁴Competitors or third parties who think they will be injured by the merger can also bring antitrust suits.

¹⁵The target has to be notified also, and it in turn informs investors. Thus the Hart–Scott–Rodino Act effectively forces an acquiring company to “go public” with its bid.

¹⁶Corporate charters and state laws sometimes specify a higher percentage.

¹⁷If B’s tangible assets are worth more than their previous book values, they would be reappraised and their current values entered on AB Corporation’s balance sheet.

¹⁸If part of the $8 million consisted of payment for identifiable intangible assets such as patents, the accountant would place these under a separate category of assets. Identifiable intangible assets that have a finite life need to be written off over their life.

¹⁹Goodwill is depreciated for tax purposes, however.

²⁰But the U.S. tax on foreign profits was not paid until the profits were brought home. Therefore, the tax could be postponed by reinvesting outside the United States Many large U.S. companies accumulated “cash mountains” overseas. See Section 30-5.

²¹See Sections 6-2 and 30-5 for descriptions of the main provisions of the 2017 Tax Cuts and Jobs Act.

²²In 1986, the directors of Revlon were held to be in breach of their duty of loyalty when they did not accept the highest bid for the firm’s stock. The Delaware Supreme Court held that when it became inevitable that the company would be sold or broken up, the “directors’ role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders.”

²³Arbitrageurs such as hedge funds speculate on the likely success of takeover bids. They specialize in deciding whether to accept a bid, wait in case someone else produces a better offer, or sell their stock in the market.

²⁴A. Agrawal and C. R. Knoeber, “Managerial Compensation and the Threat of Takeover,” Journal of Financial Economics 47 ( February 1998), pp. 219–239; and P. A. Gompers, J. L. Ishii, and A. Metrick, “Corporate Governance and Equity Prices,” Quarterly Journal of Economics 118 (2003), pp. 107–156.

²⁵In other words, the cost of the merger to A is one-half the gain ΔPV_AB.

²⁶Strictly speaking, an arbitrageur is an investor who takes a fully hedged, that is, riskless, position. But arbitrageurs in merger battles often take very large risks indeed. Their activities are known as “risk arbitrage.”

²⁷See G. Andrade, M. Mitchell, and E. Stafford, “New Evidence and Perspectives on Mergers,” Journal of Economic Perspectives 15 (Spring 2001), pp. 103–120, and J. Harford, “What Drives Merger Waves?” Journal of Financial Economics 77 (September 2005), pp. 529–560.

²⁸See G. Andrade, M. Mitchell, and E. Stafford, op. cit.

²⁹See D. J. Ravenscraft and F. M. Scherer, “Mergers and Managerial Performance,” in J. C. Coffee Jr., L. Lowenstein, and S. Rose-Ackerman, eds., Knights, Raiders, and Targets: The Impact of the Hostile Takeover (New York: Oxford University Press, 1988).

³⁰See P. Healy, K. Palepu, and R. Ruback, “Does Corporate Performance Improve after Mergers?” Journal of Financial Economics 31 (April 1992), pp. 135–175. The study examined the pretax returns of the merged companies relative to industry averages. A study by Lichtenberg and Siegel came to similar conclusions. Before merger, acquired companies had lower levels of productivity than did other firms in their industries, but by seven years after the control change, two-thirds of the productivity gap had been eliminated. See F. Lichtenberg and D. Siegel, “The Effect of Control Changes on the Productivity of U.S. Manufacturing Plants,” Journal of Applied Corporate Finance 2 (Summer 1989), pp. 60–67.

³¹Maintained levels of capital spending and R&D are also observed by Lichtenberg and Siegel, op. cit.; and B. H. Hall, “The Effect of Takeover Activity on Corporate Research and Development,” in A. J. Auerbach, ed., Corporate Takeovers: Causes and Consequences (Chicago: University of Chicago Press, 1988).

³²See S. B. Moeller, F. P. Schlingemann, and R. M. Stulz, “Wealth Destruction on a Massive Scale? A Study of Acquiring Firm Returns in the Recent Merger Wave,” Journal of Finance 60 (March 2005), pp. 757–782.

³³See U. Malmendier, E. Moretti, and F. Peters, “Winning by Losing: Evidence on the Long-Run Effects of Mergers,” The Review of Financial Studies, 31 (August 2018), pp. 3212–3264.

³⁴Warren Buffett, Berkshire Hathaway Annual Report, 1981.

³⁵K. F. McCardle and S. Viswanathan, “The Direct Entry versus Takeover Decision and Stock Price Performance around Takeovers,” Journal of Business 67 (January 1994), pp. 1–43.