Fundamentals of Financial ManagementX

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 667

of equity capital never materialized, and it had to refinance the four-year bond
issue at much higher rates.

Both Sony and its investors lost on the deal. The investors lost because they
did not get the return they expected on the issue. Sony lost because it had to
alter its financing plans because the warrants were not exercised. In spite of pre-
sumably good planning by both the company and investors, this bond-with-
warrants issue, and many like it, did not work out as anticipated.

What is a warrant?

Describe how a new bond issue with warrants is valued.

How are warrants used in corporate financing?

The use of warrants lowers the coupon rate on the corresponding
debt issue. Does this mean that the component cost of a debt-plus-
warrants package is less than the cost of straight debt? Explain.

A company recently issued bonds with attached warrants. The
bond-plus-warrants package sells at a price equal to its $1,000 face
value. The bonds mature in 10 years and have a 6 percent annual
coupon. The company also has 10-year straight debt (with no war-
rants attached) outstanding. The straight debt has a yield to matu-
rity of 8 percent. What is the straight-debt value of the bonds? What
is the value of the warrants? ($865.80; $134.20)

20.4 CONVERTIBLES Convertible Security
A security, usually a
Convertible securities are bonds or preferred stocks that, under specified terms bond or preferred
and conditions, can be exchanged for (that is, converted into) common stock at stock, that is
the option of the holder. Unlike the exercise of warrants, which brings in addi- exchangeable at the
tional funds to the firm, conversion does not provide capital: debt (or preferred option of the holder
stock) is simply replaced on the balance sheet by common stock. Of course, for the common stock
reducing the debt or preferred stock will improve the firm’s financial strength of the issuing firm.
and make it easier to raise additional capital, but that requires a separate action.
Conversion Ratio, CR
Conversion Ratio and Conversion Price The number of shares
of common stock that
One of the most important provisions of a convertible security is the conversion are obtained by con-
ratio, CR, defined as the number of shares of stock a bondholder will receive verting a convertible
upon conversion. Related to the conversion ratio is the conversion price, Pc, bond or share of con-
which is the effective price investors pay for the common stock when conversion vertible preferred
occurs. The relationship between the conversion ratio and the conversion price stock.
can be illustrated by the Silicon Valley Software Company’s convertible deben-
tures issued at their $1,000 par value in August 2005. At any time prior to matu- Conversion Price, Pc
rity on August 15, 2025, a debenture holder can exchange a bond for 20 shares of The effective price paid
common stock; therefore, the conversion ratio, CR, is 20. The bond cost pur- for common stock
chasers $1,000, the par value, when it was issued. Dividing the $1,000 par value obtained by converting
by the 20 shares received gives a conversion price of $50 a share. a convertible security.

Conversion price ϭ Pc ϭ Par value of bond given up (20-2)

Shares received

ϭ $1,000 ϭ $1,000 ϭ $50
CR 20

668 Part 7 Special Topics in Financial Management

Conversely, by solving for CR, we obtain the conversion ratio.

Conversion ratio ϭ CR ϭ $1,000 (20-3)
Pc

ϭ $1,000 ϭ 20 shares
$50

Once CR is set, the value of Pc is established, and vice versa.
Like a warrant’s exercise price, the conversion price is typically set at from

20 to 30 percent above the prevailing market price of the common stock at the
time the convertible issue is sold. Exactly how the conversion price is estab-
lished can best be understood after examining some of the reasons firms use
convertibles.

Generally, the conversion price and conversion ratio are fixed for the life of
the bond, although sometimes a stepped-up conversion price is used. For exam-
ple, the 2005 convertible debentures for Breedon Industries are convertible into
12.5 shares until 2015; into 11.76 shares from 2015 until 2025; and into 11.11
shares from 2025 until maturity in 2035. The conversion price thus starts at
$80, rises to $85, and then goes to $90. Breedon’s convertibles, like most, have a
10-year call protection period.

Another factor that may cause a change in the conversion price and ratio is a
standard feature of almost all convertibles—the clause protecting the convertible
against dilution from stock splits, stock dividends, and the sale of common stock
at prices below the conversion price. The typical provision states that if common
stock is sold at a price below the conversion price, then the conversion price
must be lowered (and the conversion ratio raised) to the price at which the new
stock was issued. Also, if the stock is split, or if a stock dividend is declared, the
conversion price must be lowered by the percentage amount of the stock divi-
dend or split. For example, if Breedon Industries were to have a two-for-one
stock split during the first 10 years of its convertible’s life, the conversion ratio
would automatically be adjusted from 12.5 to 25, and the conversion price low-
ered from $80 to $40. If this protection were not contained in the contract, a com-
pany could completely thwart conversion by the use of stock splits and stock
dividends. Warrants are similarly protected against dilution.

The standard protection against dilution from selling new stock at prices
below the conversion price can, however, get a company into trouble. For exam-
ple, assume that Breedon’s stock was selling for $65 per share at the time the
convertible was issued. Further, suppose the market went sour, and Breedon’s
stock price dropped to $50 per share. If Breedon needed new equity to support
operations, a new common stock sale would require the company to lower the
conversion price on the convertible debentures from $80 to $50. That would raise
the value of the convertibles and, in effect, transfer wealth from current share-
holders to the convertible holders. This transfer would, de facto, amount to an
additional flotation cost on the new common stock issue. Potential problems
such as this must be kept in mind by firms considering the use of convertibles or
bonds with warrants.

The Component Cost of Convertibles

In the spring of 2005, Silicon Valley Software was evaluating the use of the con-
vertible bond issue described earlier. The issue would consist of 20-year convert-
ible bonds that would sell at a price of $1,000 per bond; this $1,000 would also

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 669

be the bond’s par (and maturity) value. The bonds would pay a 10 percent
annual coupon interest rate, or $100 per year. Each bond would be convertible
into 20 shares of stock, so the conversion price would be $1,000/20 ϭ $50. The
stock was expected to pay a dividend of $2.80 during the coming year, and it
sold at $35 per share. Further, the stock price was expected to grow at a constant
rate of 8 percent per year. Therefore, rs ϭ rˆs ϭ D1/P0 ϩ g ϭ $2.80/$35 ϩ 8% ϭ
8% ϩ 8% ϭ 16%. If the bonds were not made convertible, they would have to
offer a yield of 13 percent, given their riskiness and the general level of interest
rates. The convertible bonds would not be callable for 10 years, after which they
could be called at a price of $1,050, with this price declining by $5 per year
thereafter. If, after 10 years, the conversion value exceeds the call price by at
least 20 percent, management would probably call the bonds.

Figure 20-1 shows the expectations of both an average investor and the
company.16

1. The horizontal line at M ϭ $1,000 represents the par (and maturity) value.
Also, $1,000 is the price at which the bond is initially offered to the public.

2. The bond is protected against call for 10 years. It is initially callable at a price
of $1,050, and the call price declines thereafter by $5 per year. Thus, the call
price is represented by the solid section of the line V0MЉ.

3. Since the convertible has a 10 percent coupon rate, and since the yield on a
nonconvertible bond of similar risk was stated to be 13 percent, the expected
“straight-bond” value of the convertible, Bt, must be less than par. At the
time of issue, assuming an annual coupon, B0 is $789:

Pure-debt value ϭ B0 ϭ N Coupon interest ϩ Maturity value (20-4)
at time of issue 11 ϩ rd 2 N
a 11 ϩ rd 2 t

tϭ1

20 $100 ϩ $1,000 ϭ $789
11.13 2 t 11.13 2 20
ϭa
tϭ1

Note, however, that the bond’s straight-debt value must be $1,000 just prior Conversion Value, Ct
The value of common
to maturity, so the straight-debt value rises over time. Bt follows the line stock obtained by
B0MЉ in the graph. converting a
4. The bond’s initial conversion value, Ct, or the value of the stock the investor convertible security.
would receive if the bonds were converted at t ϭ 0, is $700. The bond’s con-

version value is Pt(CR), so at t ϭ 0, Conversion value ϭ P0(CR) ϭ $35(20
shares) ϭ $700. Since the stock price is expected to grow at an 8 percent rate,

the conversion value should rise over time. For example, in Year 5 it should
be P5(CR) ϭ $35(1.08)5(20) ϭ $1,029. The expected conversion value over
time is given by the line Ct in Figure 20-1.
5. The actual market price of the bond can never fall below the higher of its

straight-debt value or its conversion value. If the market price dropped

below the straight-bond value, those who wanted bonds would recognize

the bargain and buy the convertible as a bond. Similarly, if the market price

dropped below the conversion value, people would buy the convertibles, exer-

cise them to get stock, and then sell the stock at a profit. Therefore, the higher

16 For a more complete discussion of how the terms of a convertible offering are determined, see
M. Wayne Marr and G. Rodney Thompson, “The Pricing of New Convertible Bond Issues,” Financial
Management, Summer 1984, pp. 31–37.

670 Part 7 Special Topics in Financial Management

F I G U R E 2 0 - 1 Silicon Valley Software: Convertible Bond Model

Dollars

2,000 Conversion
Value, Ct

Expected Market Value at
Time of Conversion,
C = $1,511

10

1,500 Market Value

Call Price

V0 = 1,100 M"
M = 1,000
X
B0 = 789
C0 = 700 Straight-Bond
Value, Bt

0 5 10 15 20 Years
N

Year Pure-Bond Conversion Maturity Market Floor Premium
Value, Bt Value, Ct Value, M Value Value
0 $211
1 $ 789 $ 700 $1,000 $1,000 $ 789 231
2 792 756 1,000 1,023 792 255
3 795 816 1,000 1,071 816 265
4 798 882 1,000 1,147 882 240
5 802 952 1,000 1,192 952 212
6 806 1,000 1,241 182
7 811 1,029 1,000 1,293 1,029 144
8 816 1,111 1,000 1,344 1,111 102
9 822 1,200 1,000 1,398 1,200 54
10 829 1,296 1,000 1,453 1,296 0
11 837 1,399 1,000 1,511 1,399 0
. 846 1,511 1,000 1,632 1,511 .
. . 1,632 . . 1,632 .
. . . . .
. . . . .
20 . . 0
1,000 . 1,000 3,263 .

3,263 3,263

of the bond value and conversion value curves in the graph represents a floor
price for the bond. In Figure 20-1, the floor price is represented by the thicker
shaded line B0XCt.
6. The bond’s market value will typically exceed its floor value. It will exceed
the straight-bond value because the option to convert is worth something—
a 10 percent bond with conversion possibilities is worth more than a 10 per-
cent bond without this option. The convertible’s price will also exceed its
conversion value because holding the convertible is equivalent to holding a
call option, and, prior to expiration, the option’s true value is higher than its

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 671

expiration (or conversion) value. Without using a sophisticated pricing
model, we cannot say exactly where the market value line will lie, but as a
rule it will be at or above the floor set by the straight-bond and conversion
value lines.
7. At some point, the market value line will touch the conversion value line.
This convergence will occur for two reasons. First, the stock should pay
higher and higher dividends as the years go by, but the interest payments on
the convertible are fixed. For example, Silicon’s convertibles would pay $100
in interest annually, while the dividends on the 20 shares received upon con-
version would initially be 20($2.80) ϭ $56. However, at an 8 percent growth
rate, the dividends after ten years would be up to $120.90, while the interest
would still be $100. Thus, at some point, rising dividends could be expected
to push against the fixed interest payments, causing the premium to disap-
pear and investors to convert voluntarily. Second, once the bond becomes
callable, its market value cannot exceed the higher of the conversion value
and the call price without exposing investors to the danger of a call. For
example, suppose that 10 years after issue (when the bonds were callable),
the market value of the bond was $1,600, the conversion value was $1,500,
and the call price was $1,050. If the company called the bonds the day after
you bought 10 bonds for $16,000, you would be forced to convert into stock
worth only $15,000, so you would suffer a loss of $100 per bond, or $1,000, in
one day. Recognizing this danger, you and other investors would simply not
pay a premium over the higher of the call price or the conversion value once
the bond becomes callable. Therefore, in Figure 20-1, we assume that the
market value line hits the conversion value line in Year 10, when the bond
becomes callable.
8. Let N represent the year when investors expect conversion to occur, either
voluntarily because of rising dividends or because the company calls the
convertibles to strengthen its balance sheet by substituting equity for debt. In
our example, we assume that N ϭ 10, the first call date.
9. Since N ϭ 10, the expected market value at Year 10 is $35(1.08)10(20) ϭ
$1,511. An investor can find the expected rate of return on the convertible
bond, rc, by finding the IRR of the following cash flow stream:

0 1 9 10
Ϫ1‚000 100
100 100
1,511
1,611

The solution is rc ϭ IRR ϭ 12.8%.
10. The return on a convertible is expected to come partly from interest income

and partly from capital gains; in this case, the total expected return is 12.8

percent, with 10 percent representing interest income and 2.8 percent repre-

senting the expected capital gain. The interest component is relatively

assured, while the capital gain component is more risky. Therefore, a con-

vertible’s expected return is more risky than that of a straight bond. This

leads us to conclude that rc should be larger than the cost of straight debt, rd.
Thus, it would seem that the expected rate of return on Silicon’s convertibles,

rc, should lie between its cost of straight debt, rd ϭ 13%, and its cost of
common stock, rs ϭ 16%.
11. Investment bankers use the type of model described here, plus a knowledge

of the market, to set the terms on convertibles (the conversion ratio, coupon

interest rate, and years of call protection) such that the security will just

672 Part 7 Special Topics in Financial Management

“clear the market” at its $1,000 offering price. In our example, the required
conditions do not hold—the calculated rate of return on the convertible is
only 12.8 percent, which is less than the 13 percent cost of straight debt.
Therefore, the terms on the bond must be made more attractive to investors.
Silicon Valley Software would have to increase the coupon interest rate on
the convertible above 10 percent, raise the conversion ratio above 20 (and
thereby lower the conversion price from $50 to a level closer to the current
$35 market price of the stock), lengthen the call-protected period, or use a
combination of these three such that the expected return on the convertible
ends up between 13 and 16 percent.17

Use of Convertibles in Financing

Convertibles have two important advantages from the issuer’s standpoint:
(1) Convertibles, like bonds with warrants, offer a company the chance to sell
debt with a low interest rate in exchange for a chance to participate in the com-
pany’s success if it does well. (2) In a sense, convertibles provide a way to sell
common stock at prices higher than those currently prevailing. Some companies
actually want to sell common stock, not debt, but feel that the price of their stock
is temporarily depressed. Management may know, for example, that earnings
are depressed because of startup costs associated with a new project, but they
expect earnings to rise sharply during the next year or so, pulling the price of
the stock up with them. Thus, if the company sold stock now, it would be giving
up more shares than necessary to raise a given amount of capital. However, if it
set the conversion price 20 to 30 percent above the present market price of the
stock, then 20 to 30 percent fewer shares would be given up when the bonds
were converted than if stock were sold directly at the current time. Note, how-
ever, that management is counting on the stock’s price to rise above the conver-
sion price to make the bonds attractive in conversion. If earnings do not rise and
pull the stock price up, hence conversion does not occur, then the company will
be saddled with debt in the face of low earnings, which could be disastrous.

How can the company be sure that conversion will occur if the price of the
stock rises above the conversion price? Typically, convertibles contain a call pro-
vision that enables the issuing firm to force holders to convert. Suppose the con-
version price is $50, the conversion ratio is 20, the market price of the common
stock has risen to $60, and the call price on a convertible bond is $1,050. If the
company calls the bond, bondholders can either convert into common stock with
a market value of 20($60) ϭ $1,200 or allow the company to redeem the bond for
$1,050. Naturally, bondholders prefer $1,200 to $1,050, so conversion would
occur. The call provision gives the company a way to force conversion, provided
the market price of the stock is greater than the conversion price. Note, however,
that most convertibles have a fairly long period of call protection—10 years is
typical. Therefore, if the company wants to be able to force conversion fairly
early, then it will have to set a short call-protection period. This will, in turn,
require that it set a higher coupon rate or a lower conversion price.

From the standpoint of the issuer, convertibles have three important disad-
vantages: (1) Although the use of a convertible bond may give the company the
opportunity to sell stock at a price higher than the price at which it could be sold
currently, if the stock greatly increases in price, the firm would probably find
that it would have been better off if it had used straight debt in spite of its

17 In this discussion, we ignore the tax advantages to investors associated with capital gains. In
some situations, tax effects could result in rc being less than rd.

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 673

higher cost and then later sold common stock and refunded the debt. (2) Con-
vertibles typically have a low coupon interest rate, and the advantage of this
low-cost debt will be lost when conversion occurs. (3) If the company truly
wants to raise equity capital, and if the price of the stock does not rise suffi-
ciently after the bond is issued, then the company will be stuck with debt.

Convertibles and Conflicts of Interest

A potential conflict of interest between bondholders and stockholders is asset
substitution. Stockholders have an “option-related” incentive to take on projects
with high upside potential even though they increase the risk of the firm. When
such an action is taken, there is potential for a wealth transfer between bondhold-
ers and stockholders. However, when convertible debt is issued, actions that
increase the risk of the company may also increase the value of the convertible
debt. Thus, some of the gains to shareholders from taking on high-risk projects
have to be shared with convertible bondholders. This sharing of benefits reduces
conflicts of interest between bondholders and stockholders. The same general
logic applies to convertible preferred and to warrants.

What is a conversion ratio? A conversion price? A straight-bond value?

What is meant by a convertible’s floor value?

What are the advantages and disadvantages of convertibles to
issuers? To investors?

How do convertibles reduce possible conflicts of interest between
bondholders and stockholders?

A convertible bond has a par value of $1,000 and a conversion price
of $40. The stock currently trades for $30 a share. What are the
bond’s conversion value and conversion ratio at t ϭ 0? [CR ϭ 25;
P0(CR) ϭ $30 ϫ $25 ϭ $750]

20.5 A FINAL COMPARISON OF WARRANTS
AND CONVERTIBLES

Convertible debt can be thought of as straight debt with nondetachable war-
rants. Thus, at first blush, it might appear that debt with warrants and convert-
ible debt are more or less interchangeable. However, a closer look reveals one
major and several minor differences between these two securities.18 First, as we
discussed previously, the exercise of warrants brings in new equity capital, while
the conversion of convertibles results only in an accounting transfer.

A second difference involves flexibility. Most convertible issues contain a call
provision that allows the issuer either to refund the debt or to force conversion,
depending on the relationship between the conversion value and call price.
However, most warrants are not callable, so firms generally must wait until
maturity for the warrants to generate new equity capital. Generally, maturities
also differ between warrants and convertibles. Warrants typically have much

18 For a more detailed comparison of warrants and convertibles, see Michael S. Long and Stephen F.
Sefcik, “Participation Financing: A Comparison of the Characteristics of Convertible Debt and
Straight Bonds Issued in Conjunction with Warrants,” Financial Management, Autumn 1990,
pp. 23–34.

674 Part 7 Special Topics in Financial Management

shorter maturities than convertibles, and warrants typically expire before their
accompanying debt matures. Further, warrants provide for fewer future common
shares than do convertibles because with convertibles all of the debt is converted
to common whereas debt remains outstanding when warrants are exercised.
Together, these facts suggest that debt-plus-warrant issuers are actually more
interested in selling debt than in selling equity.

In general, firms that issue debt with warrants are smaller and riskier than
those that issue convertibles. One possible rationale for the use of option securi-
ties, especially the use of debt with warrants by small firms, is the difficulty
investors have assessing the risk of small companies. If a startup with a new,
untested product seeks debt financing, it is very difficult for potential lenders to
judge the risk of the venture, hence it is difficult to set a fair interest rate. Under
these circumstances, many potential investors will be reluctant to invest, making
it necessary to set very high interest rates to attract debt capital. By issuing debt
with warrants, investors obtain a package that offers upside potential to offset
the risks of loss.

Finally, there is a significant difference in issuance costs between debt with
warrants and convertible debt. Bonds with warrants typically require issuance
costs that are about 1.2 percent more than the flotation costs for convertibles. In
general, bond-with-warrant financings have underwriting fees that closely reflect
the weighted average of the fees associated with debt and equity issues, while
underwriting costs for convertibles are substantially lower.

What are some differences between debt-with-warrant financing
and convertible debt?

Explain how bonds with warrants might help small, risky firms sell
debt securities.

20.6 REPORTING EARNINGS WHEN
WARRANTS OR CONVERTIBLES
ARE OUTSTANDING19

If warrants or convertibles are outstanding, a firm could theoretically report
earnings per share in one of three ways:

1. Basic EPS, where earnings available to common stockholders are divided by
the average number of shares actually outstanding during the period.

2. Primary EPS, where earnings available are divided by the average number of
shares that would have been outstanding if warrants and convertibles “likely
to be converted in the near future” had actually been exercised or converted.
In calculating primary EPS, earnings are first adjusted by “backing out” the
interest on the convertibles, after which the adjusted earnings are divided by
the adjusted number of shares. Accountants have a formula that basically
compares the conversion or exercise price with the actual market value of the

19 As part of the FASB’s short-term convergence project with the IASB, to improve financial report-
ing in the U.S. while concurrently eliminating individual differences between U.S. GAAP and inter-
national financial reporting standards, the FASB expects to issue a final statement in the first quarter
of 2006 that will make additional changes to FASB #128 (issued in February 1997), which is dis-
cussed in this section.

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 675

stock to determine the likelihood of conversion when deciding on the need
to use this adjustment procedure.
3. Diluted EPS, which is similar to primary EPS except that all warrants and
convertibles are assumed to be exercised or converted, regardless of the like-
lihood of exercise or conversion.

Under SEC rules, firms are required to report both basic and diluted EPS.
For firms with large amounts of option securities outstanding, there can be a
substantial difference between the basic and diluted EPS figures. For financial
statement purposes, firms reported diluted EPS until 1997, when the Financial
Accounting Standards Board (FASB) changed to basic EPS. According to FASB,
the change was made to give investors a simpler picture of a company’s under-
lying performance. Also, the change makes it easier for investors to compare the
performance of U.S. firms with their foreign counterparts, which tend to use
basic EPS.

What are the three possible methods for reporting EPS when war-
rants and convertibles are outstanding?

Which methods are most used in practice?

Why should investors be concerned about a firm’s outstanding war-
rants and convertibles?

Tying It All Together

While common stock and long-term debt provide most of the capital used by corpo-
rations, companies also use several forms of “hybrid securities.” The hybrids include
preferred stock, leasing, convertibles, and warrants, and they generally have some
characteristics of debt and some of equity. We discussed the pros and cons of the
hybrids from the standpoints of both issuers and investors, how to determine when
to use them, and the factors that affect their values. The basic rationale for these
securities, and the procedures used to evaluate them, are based on concepts devel-
oped in earlier chapters.

SELF-TEST QUESTIONS AND PROBLEMS
(Solutions Appear in Appendix A)

ST-1 Key terms Define each of the following terms:

a. Cumulative dividends; adjustable rate preferred stock
b. Arrearages; market auction preferred
c. Lessee; lessor
d. Sale and leaseback; operating lease; financial lease
e. Off balance sheet financing; FASB #13
f. Residual value
g. Warrant; detachable warrant; stepped-up exercise price

676 Part 7 Special Topics in Financial Management

ST-2 h. Convertible security; conversion ratio, CR; conversion price, Pc; conversion value, Ct
i. Basic EPS; primary EPS; diluted EPS

Lease analysis The Olsen Company has decided to acquire a new truck. One alternative is
to lease the truck on a 4-year contract for a lease payment of $10,000 per year, with pay-
ments to be made at the beginning of each year. The lease would include maintenance.
Alternatively, Olsen could purchase the truck outright for $40,000, financing with a bank
loan for the net purchase price, amortized over a 4-year period at an interest rate of 10 per-
cent per year, payments to be made at the end of each year. Under the borrow-to-purchase
arrangement, Olsen would have to maintain the truck at a cost of $1,000 per year, payable
at year-end. The truck falls into the MACRS 3-year class. The applicable MACRS deprecia-
tion rates are 33, 45, 15, and 7 percent. It has a salvage value of $10,000, which is the
expected market value after 4 years, at which time Olsen plans to replace the truck irre-
spective of whether it leases or buys. Olsen has a federal-plus-state tax rate of 40 percent.

a. What is Olsen’s PV cost of leasing?
b. What is Olsen’s PV cost of owning? Should the truck be leased or purchased?
c. The appropriate discount rate for use in Olsen’s analysis is the firm’s after-tax cost

of debt. Why?
d. The salvage value is the least certain cash flow in the analysis. How might Olsen

incorporate the higher riskiness of this cash flow into the analysis?

QUESTIONS

20-1 For purposes of measuring a firm’s leverage, should preferred stock be classified as debt
or equity? Does it matter if the classification is being made (a) by the firm’s manage-
ment, (b) by creditors, or (c) by equity investors?

20-2 You are told that one corporation just issued $100 million of preferred stock and another
purchased $100 million of preferred stock as an investment. You are also told that one
firm has an effective tax rate of 20 percent, whereas the other is in the 35 percent bracket.
Which firm is more likely to have bought the preferred? Explain.

20-3 A company’s bonds are often found to have a higher yield than its preferred stock, even
though the bonds are considered to be less risky than the preferred to an investor. What
causes this yield differential?

20-4 Why would a company choose to issue floating-rate as opposed to fixed-rate preferred
stock?

20-5 Distinguish between operating leases and financial leases. Would a firm be more likely
to finance a fleet of trucks or a manufacturing plant with an operating lease?

20-6 One alleged advantage of leasing voiced in the past was that it kept liabilities off the bal-
ance sheet, thus making it possible for a firm to obtain more leverage than it otherwise
could have. This raised the question of whether or not both the lease obligation and the
asset involved should be capitalized and shown on the balance sheet. Discuss the pros
and cons of capitalizing leases and related assets.

20-7 Suppose there were no IRS restrictions on what constitutes a valid lease. Explain in a
manner that a legislator might understand why some restrictions should be imposed.

20-8 Suppose Congress changed the tax laws in a way that (a) permitted equipment to be
depreciated over a shorter period, (b) lowered corporate tax rates, and (c) reinstated the
investment tax credit. Discuss how each of these changes would affect the relative use of
leasing versus conventional debt in the U.S. economy.

20-9 What effect does the expected growth rate of a firm’s stock price (subsequent to issue)
have on its ability to raise additional funds through (a) convertibles and (b) warrants?

20-10 a. How would a firm’s decision to pay out a higher percentage of its earnings as
dividends affect each of the following?

(1) The value of its long-term warrants.
(2) The likelihood that its convertible bonds will be converted.
(3) The likelihood that its warrants will be exercised.
b. If you owned the warrants or convertibles of a company, would you be pleased or
displeased if it raised its payout rate from 20 to 80 percent? Why?

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 677

20-11 Evaluate the following statement: “Issuing convertible securities represents a means by
20-12 which a firm can sell common stock at a price above the existing market price.”

Suppose a company simultaneously issues $50 million of convertible bonds with a coupon
rate of 9 percent and $50 million of pure bonds with a coupon rate of 12 percent. Both
bonds have the same maturity. Does the fact that the convertible issue has the lower coupon
rate suggest that it is less risky than the pure bond? Would you regard the cost of capital as
being lower on the convertible than on the pure bond? Explain. (Hint: Although it might
appear at first glance that the convertible’s cost of capital is lower, this is not necessarily the
case because the interest rate on the convertible understates its cost. Think about this.)

PROBLEMS

Easy 20-1 Leasing Connors Construction needs a piece of equipment that can either be leased or
Problems 1–3 purchased. The equipment costs $100. One option is to borrow $100 from the local bank
20-2 and use the money to buy the equipment. The other option is to lease the equipment. If
Intermediate 20-3 Connors chooses to lease the equipment, it would not capitalize the lease on the balance
Problems 4–7 20-4 sheet. Below is the company’s balance sheet prior to the purchase or leasing of the
equipment:
20-5
Current assets $300 Debt $400
Fixed assets 500 Equity 400
Total assets Total liabilities and equity
$800 $800

What would be the company’s debt ratio if it chose to purchase the equipment? What
would be the company’s debt ratio if it chose to lease the equipment? Would the com-
pany’s financial risk be different depending on whether the equipment was leased or
purchased?

Warrants Gregg Company recently issued two types of bonds. The first issue consisted
of 20-year straight (no warrants attached) bonds with an 8 percent annual coupon. The
second issue consisted of 20-year bonds with a 6 percent annual coupon with warrants
attached. Both bonds were issued at par ($1,000). What is the value of the warrants that
were attached to the second issue?

Convertibles Petersen Securities recently issued convertible bonds with a $1,000 par
value. The bonds have a conversion price of $40 a share. What is the bonds’ conversion
ratio, CR?

Balance sheet effects of leasing Two textile companies, McDaniel-Edwards Manufactur-
ing and Jordan-Hocking Mills, began operations with identical balance sheets. A year
later, both required additional manufacturing capacity at a cost of $200,000. McDaniel-
Edwards obtained a 5-year, $200,000 loan at an 8 percent interest rate from its bank.
Jordan-Hocking, on the other hand, decided to lease the required $200,000 capacity from
National Leasing for 5 years; an 8 percent return was built into the lease. The balance
sheet for each company, before the asset increases, is as follows:

Debt $200,000

Equity 200,000

Total assets $400,000 Total liabilities and equity $400,000

a. Show the balance sheet of each firm after the asset increase, and calculate each
firm’s new debt ratio. (Assume Jordan-Hocking’s lease is kept off the balance sheet.)

b. Show how Jordan-Hocking’s balance sheet would have looked immediately after the
financing if it had capitalized the lease.

c. Would the rate of return (1) on assets and (2) on equity be affected by the choice of
financing? How?

Lease versus buy Morris-Meyer Mining Company must install $1.5 million of new
machinery in its Nevada mine. It can obtain a bank loan for 100 percent of the required
amount. Alternatively, a Nevada investment banking firm that represents a group of
investors believes that it can arrange for a lease financing plan. Assume that the follow-
ing facts apply:

(1) The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33,
45, 15, and 7 percent.

678 Part 7 Special Topics in Financial Management

Challenging 20-6 (2) Estimated maintenance expenses are $75,000 per year.
Problems 8–10 (3) Morris-Meyer’s federal-plus-state tax rate is 40 percent.
20-7 (4) If the money is borrowed, the bank loan will be at a rate of 15 percent, amortized in
20-8
4 equal installments to be paid at the end of each year.
(5) The tentative lease terms call for end-of-year payments of $400,000 per year for 4 years.
(6) Under the proposed lease terms, the lessee must pay for insurance, property taxes,

and maintenance.
(7) Morris-Meyer must use the equipment if it is to continue in business, so it will

almost certainly want to acquire the property at the end of the lease. If it does, then
under the lease terms, it can purchase the machinery at its fair market value at that
time. The best estimate of this market value is the $250,000 salvage value, but it
could be much higher or lower under certain circumstances.

To assist management in making the proper lease-versus-buy decision, you are asked to
answer the following questions.

a. Assuming that the lease can be arranged, should Morris-Meyer lease, or should it
borrow and buy the equipment? Explain.

b. Consider the $250,000 estimated salvage value. Is it appropriate to discount it at the
same rate as the other cash flows? What about the other cash flows—are they all
equally risky? (Hint: Riskier cash flows are normally discounted at higher rates, but
when the cash flows are costs rather than inflows, the normal procedure must be
reversed.)

Warrants Pogue Industries Inc. has warrants outstanding that permit its holders to pur-
chase 1 share of stock per warrant at a price of $21. (Refer to Chapter 18 for parts a, b,
and c.)

a. Calculate the exercise value of Pogue’s warrants if the common stock sells at each of
the following prices: $18, $21, $25, and $70.

b. At what approximate price do you think the warrants would actually sell under
each condition indicated in part a? What premium is implied in your price? Your
answer will be a guess, but your prices and premiums should bear reasonable rela-
tionships to each other.

c. How would each of the following factors affect your estimates of the warrants’
prices and premiums in part b?

(1) The life of the warrant is lengthened.
(2) The expected variability (␴p) in the stock’s price decreases.
(3) The expected growth rate in the stock’s EPS increases.
(4) The company announces the following change in dividend policy: whereas it

formerly paid no dividends, henceforth it will pay out all earnings as dividends.
d. Assume Pogue’s stock now sells for $18 per share. The company wants to sell some

20-year, annual interest, $1,000 par value bonds. Each bond will have 50 warrants,
each exercisable into 1 share of stock at an exercise price of $21. Pogue’s pure bonds
yield 10 percent. Regardless of your answer to part b, assume that the warrants will
have a market value of $1.50 when the stock sells at $18. What annual coupon inter-
est rate and annual dollar coupon must the company set on the bonds with warrants
if they are to clear the market? Round to the nearest dollar or percentage point.

Convertibles The Hadaway Company was planning to finance an expansion in the sum-
mer of 2005 with a convertible security. They considered a convertible debenture but
feared the burden of fixed interest charges if the common stock did not rise enough to
make conversion attractive. They decided on an issue of convertible preferred stock,
which would pay a dividend of $1.05 per share.

The common stock was selling for $21 a share at the time. Management projected
earnings for 2005 at $1.50 a share and expected a future growth rate of 10 percent a year in
2006 and beyond. It was agreed by the investment bankers and management that the com-
mon stock would continue to sell at 14 times earnings, the current price/earnings ratio.

a. What conversion price should be set by the issuer? The conversion rate will be 1.0; that
is, each share of convertible preferred can be converted into 1 share of common. There-
fore, the convertible’s par value (as well as the issue price) will be equal to the conver-
sion price, which, in turn, will be determined as a percentage over the current market
price of the common. Your answer will be a guess, but make it a reasonable one.

b. Should the preferred stock include a call provision? Why or why not?

Lease analysis As part of its overall plant modernization and cost reduction program,
the management of Tanner-Woods Textile Mills has decided to install a new automated

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 679

20-9 weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project
was found to be 20 percent versus a project required return of 12 percent.

The loom has an invoice price of $250,000, including delivery and installation
charges. The funds needed could be borrowed from the bank through a 4-year amortized
loan at a 10 percent interest rate, with payments to be made at the end of each year. In
the event that the loom is purchased, the manufacturer will contract to maintain and ser-
vice it for a fee of $20,000 per year paid at the end of each year. The loom falls in the
MACRS 5-year class, and Tanner-Woods’s marginal federal-plus-state tax rate is 40 per-
cent. The applicable MACRS rates are 20, 32, 19, 12, 11, and 6 percent.

United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-
Woods for $70,000 upon delivery and installation (at t ϭ 0) plus 4 additional annual
lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there
are 5 lease payments in total.) The lease agreement includes maintenance and servicing.
Actually, the loom has an expected life of 8 years, at which time its expected salvage
value is zero; however, after 4 years, its market value is expected to equal its book value
of $42,500. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no
interest in either leasing or owning the proposed loom for more than that period.

a. Should the loom be leased or purchased?
b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume

that the appropriate salvage value pre-tax discount rate is 15 percent. What would
be the effect of a salvage value risk adjustment on the decision?
c. The original analysis assumed that Tanner-Woods would not need the loom after 4
years. Now assume that the firm will continue to use it after the lease expires. Thus,
if it leased, Tanner-Woods would have to buy the asset after 4 years at the then
existing market value, which is assumed to equal the book value. What effect would
this requirement have on the basic analysis? (No numerical analysis is required; just
verbalize.)

Financing alternatives The Howe Computer Company has grown rapidly during the
past 5 years. Recently, its commercial bank urged the company to consider increasing its
permanent financing. Its bank loan under a line of credit has risen to $150,000, carrying a
10 percent interest rate, and Howe has been 30 to 60 days late in paying trade creditors.

Discussions with an investment banker have resulted in the decision to raise
$250,000 at this time. Investment bankers have assured Howe that the following alterna-
tives are feasible (flotation costs will be ignored):

• Alternative 1: Sell common stock at $10 per share.
• Alternative 2: Sell convertible bonds at a 10 percent coupon, convertible into 80 shares

of common stock for each $1,000 bond (that is, the conversion price is $12.50 per share).
• Alternative 3: Sell debentures with a 10 percent coupon; each $1,000 bond will have

80 warrants to buy 1 share of common stock at $12.50.

Keith Howe, the president, owns 80 percent of Howe’s common stock and wishes to
maintain control of the company; 50,000 shares are outstanding. The following are sum-
maries of Howe’s latest financial statements:

Balance Sheet

Total assets $275,000 Current liabilities $200,000
Common stock, $1 par 50,000
Retained earnings 25,000
Total liabilities and equity
$275,000

Income Statement

Sales $550,000
All costs except interest 495,000
EBIT $ 55,000
Interest 15,000
EBT $ 40,000
Taxes (40%) 16,000
Net income $ 24,000

Shares outstanding 50,000
Earnings per share $0.48
Price/earnings ratio 18ϫ
Market price of stock $8.64

680 Part 7 Special Topics in Financial Management

20-10 a. Show the new balance sheet under each alternative. For Alternatives 2 and 3, show
the balance sheet after conversion of the debentures or exercise of the warrants.
Assume that $150,000 of the funds raised will be used to pay off the bank loan and
the rest to increase total assets.

b. Show Howe’s control position under each alternative, assuming that he does not
purchase additional shares.

c. What is the effect on earnings per share of each alternative if it is assumed that earn-
ings before interest and taxes will be 20 percent of total assets?

d. What will be the debt ratio under each alternative?
e. Which of the three alternatives would you recommend to Howe, and why?

Convertibles O’Brien Computers Inc. needs to raise $35 million to begin producing
a new microcomputer. O’Brien’s straight, nonconvertible debentures currently yield
12 percent. Its stock sells for $38 per share, the last dividend was $2.46, and the expected
growth rate is a constant 8 percent. Investment bankers have tentatively proposed that
O’Brien raise the $35 million by issuing convertible debentures. These convertibles
would have a $1,000 par value, carry an annual coupon rate of 10 percent, have a 20-year
maturity, and be convertible into 20 shares of stock. The bonds would be noncallable for
5 years, after which they would be callable at a price of $1,075; this call price would
decline by $5 per year in Year 6 and each year thereafter. Management has called con-
vertibles in the past (and presumably will call them again in the future), once they were
eligible for call, as soon as their conversion value was about 20 percent above their par
value (not their call price).

a. Draw an accurate graph similar to Figure 20-1 representing the expectations set
forth in the problem.

b. Suppose the previously outlined projects work out on schedule for 2 years, but
then O’Brien begins to experience extremely strong competition from Japanese
firms. As a result, O’Brien’s expected growth rate drops from 8 percent to zero.
Assume that the dividend at the time of the drop is $2.87. The company’s credit
strength is not impaired, and its value of rs is also unchanged. What would hap-
pen (1) to the stock price and (2) to the convertible bond’s price? Be as precise as
you can.

COMPREHENSIVE/SPREADSHEET
PROBLEMS

20-11 Lease analysis Use the spreadsheet model to rework parts a and b of Problem 20-8.
20-12 Then, answer the following question.

c. Accepting that the corporate WACC should be used equally to discount all
anticipated cash flows, at what cost of capital would the firm be indifferent
between leasing and buying?

Warrants Storm Software wants to issue $100 million in new capital to fund new
opportunities. If Storm were to raise the $100 million of new capital in a straight-debt
20-year bond offering, Storm would have to offer an annual coupon rate of 12 percent.
However, Storm’s advisors have suggested a 20-year bond offering with warrants.
According to the advisors, Storm could issue 9 percent annual coupon-bearing debt
with 20 warrants per $1,000 face value bond. Storm has 10 million shares of stock
outstanding at a current price of $25. The warrants can be exercised in 10 years (on
December 31, 2015) at an exercise price of $30. Each warrant entitles its holder to buy
1 share of Storm Software stock. After issuing the bonds with warrants, Storm’s
operations and investments are expected to grow at a constant rate of 10 percent per
year.

a. If investors pay $1,000 for each bond, what is the value of each warrant attached to
the bond issue?

b. What is the expected total value of Storm Software in 10 years?
c. If there were no warrants, what would be Storm’s price per share in 10 years? What

would be the price with the warrants?
d. What is the component cost of these bonds with warrants? What is the premium

associated with the warrants?

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 681

Integrated Case

Fish & Chips, Inc., Part I

20-13 Lease analysis Martha Millon, financial manager for Fish & Chips Inc., has been asked to perform a lease-versus-
buy analysis on a new computer system. The computer costs $1,200,000, and, if it is purchased, Fish & Chips
could obtain a term loan for the full amount at a 10 percent cost. The loan would be amortized over the
4-year life of the computer, with payments made at the end of each year. The computer is classified as special
purpose, and hence it falls into the MACRS 3-year class. The applicable MACRS rates are 33, 45, 15, and 7 per-
cent. If the computer is purchased, a maintenance contract must be obtained at a cost of $25,000, payable at the
beginning of each year.

After 4 years, the computer will be sold, and Millon’s best estimate of its residual value at that time is
$125,000. Because technology is changing rapidly, however, the residual value is very uncertain.

As an alternative, National Leasing is willing to write a 4-year lease on the computer, including maintenance,
for payments of $340,000 at the beginning of each year. Fish & Chips’ marginal federal-plus-state tax rate is 40
percent. Help Millon conduct her analysis by answering the following questions.

a. (1) Why is leasing sometimes referred to as “off balance sheet” financing?
(2) What is the difference between a capital lease and an operating lease?
(3) What effect does leasing have on a firm’s capital structure?

b. (1) What is Fish & Chips’ present value cost of owning the computer? (Hint: Set up a table whose bottom
line is a “time line” that shows the net cash flows over the period t ϭ 0 to t ϭ 4, and then find the PV of
these net cash flows, or the PV cost of owning.)

(2) Explain the rationale for the discount rate you used to find the PV.
c. (1) What is Fish & Chips’ present value cost of leasing the computer? (Hint: Again, construct a time line.)

(2) What is the net advantage to leasing? Does your analysis indicate that the firm should buy or lease the
computer? Explain.

d. Now assume that Millon believes the computer’s residual value could be as low as $0 or as high as $250,000,
but she stands by $125,000 as her expected value. She concludes that the residual value is riskier than the
other cash flows in the analysis, and she wants to incorporate this differential risk into her analysis. Describe
how this could be accomplished. What effect would it have on the lease decision?

e. Millon knows that her firm has been considering moving its headquarters to a new location for some time,
and she is concerned that these plans may come to fruition prior to the expiration of the lease. If the move
occurs, the company would obtain completely new computers, and hence Millon would like to include a
cancellation clause in the lease contract. What effect would a cancellation clause have on the riskiness of the
lease?

Fish & Chips, Inc., Part II

20-14 Preferred stock, warrants, and convertibles Martha Millon, financial manager of Fish & Chips Inc., is facing a
dilemma. The firm was founded 5 years ago to develop a new fast-food concept, and although Fish & Chips has
done well, the firm’s founder and chairman believes that an industry shake-out is imminent. To survive, the firm
must capture market share now, and this requires a large infusion of new capital.

Because the stock price may rise rapidly, Millon does not want to issue new common stock. On the other
hand, interest rates are currently very high by historical standards, and, with the firm’s B rating, the interest pay-
ments on a new debt issue would be too much to handle if sales took a downturn. Thus, Millon has narrowed her
choice to bonds with warrants or convertible bonds. She has asked you to help in the decision process by answer-
ing the following questions.

a. How does preferred stock differ from common equity and debt?
b. What is floating-rate preferred?
c. How can a knowledge of call options provide an understanding of warrants and convertibles?
d. One of Millon’s alternatives is to issue a bond with warrants attached. Fish & Chips’ current stock price is

$10, and its cost of 20-year, annual coupon debt without warrants is estimated by its investment bankers to
be 12 percent. The bankers suggest attaching 50 warrants to each bond, with each warrant having an exercise
price of $12.50. It is estimated that each warrant, when detached and traded separately, will have a value
of $1.50.

(1) What coupon rate should be set on the bond with warrants if the total package is to sell for $1,000?

682 Part 7 Special Topics in Financial Management

(2) Suppose the bonds are issued and the warrants immediately trade for $2.50 each. What does this
imply about the terms of the issue? Did the company “win” or “lose”?

(3) When would you expect the warrants to be exercised?
(4) Will the warrants bring in additional capital when exercised? If so, how much and what type of

capital?
(5) Because warrants lower the cost of the accompanying debt, shouldn’t all debt be issued with war-

rants? What is the expected cost of the bond with warrants if the warrants are expected to be exer-
cised in 5 years, when Fish & Chips’ stock price is expected to be $17.50? How would you expect the
cost of the bond with warrants to compare with the cost of straight debt? With the cost of common
stock?
e. As an alternative to the bond with warrants, Millon is considering convertible bonds. The firm’s invest-
ment bankers estimate that Fish & Chips could sell a 20-year, 10 percent annual coupon, callable convert-
ible bond for its $1,000 par value, whereas a straight-debt issue would require a 12 percent coupon. Fish
& Chips’ current stock price is $10, its last dividend was $0.74, and the dividend is expected to grow at a
constant rate of 8 percent. The convertible could be converted into 80 shares of Fish & Chips stock at the
owner’s option.

(1) What conversion price, Pc, is implied in the convertible’s terms?
(2) What is the straight-debt value of the convertible? What is the implied value of the convertibility

feature?
(3) What is the formula for the bond’s conversion value in any year? Its value at Year 0? At Year 10?
(4) What is meant by the term “floor value” of a convertible? What is the convertible’s expected floor

value in Year 0? In Year 10?
(5) Assume that Fish & Chips intends to force conversion by calling the bond when its conversion value

is 20 percent above its par value, or at 1.2($1,000) ϭ $1,200. When is the issue expected to be called?
Answer to the closest year.
(6) What is the expected cost of the convertible to Fish & Chips? Does this cost appear consistent with
the riskiness of the issue? Assume conversion in Year 5 at a conversion value of $1,200.
f. Millon believes that the costs of both the bond with warrants and the convertible bond are essentially
equal, so her decision must be based on other factors. What are some of the factors that she should
consider in making her decision?

Please go to the ThomsonNOW Web site to access the
Cyberproblems.

HAPTE

21

MERGERS AND ACQUISITIONS
© MIKE SIMONS/GETTY IMAGES INC. R

C Procter & Gamble Acquires Gillette Procter & Gamble

Over the past several years a series of large mergers have reshaped the
corporate landscape. Recent events suggest that this trend is showing no signs
of slowing down. Within the first three months of 2005, plans for four major
mergers were announced: Procter & Gamble’s $55 billion bid for Gillette, SBC
Communications’ $14.7 billion acquisition of AT&T Corp., Federated Depart-
ment Store’s $10.5 billion acquisition of May Department Store, and Verizon’s
$7.5 billion revised bid for MCI Inc.

Combining consumer products giants Procter & Gamble (P&G) and Gillette
immediately produced several winners. When the deal was announced, Gillette’s
shareholders saw the value of their stock rise by more than 17 percent. One
particular winner was Gillette’s largest shareholder, Warren Buffett, who owned
roughly 96 million shares. Other winners include Gillette’s senior executives,
who saw the values of their stock and stock options increase, and the invest-
ment banks that helped put the deal together. (Estimates suggest that Goldman
Sachs, Merrill Lynch, and UBS each received $30 million from the transaction.)

What remains to be seen is whether the deal makes sense for P&G’s share-
holders. While many have applauded the deal, others suggest that P&G will
have to work hard to justify the price it paid for Gillette. Moreover, as we point
out in this chapter, the track record for acquiring firms in large deals has not
always been that good.

In an article written for The Wall Street Journal, shortly after the
P&G–Gillette announced deal, David Hardin and Sam Rovit discuss the poten-
tial pitfalls of large acquisitions, and they estimate that only 3 out of 10 large
deals between 1995 and 2001 created meaningful benefits for the acquiring
firm’s shareholders. Hardin and Rovit (who are Bain & Company partners and
co-authors of a recent book entitled Mastering the Merger: Four Critical
Decisions That Make or Break a Deal) argue that there are five major criteria
that determine whether a merger is successful:

1. Is management successful in deal making? They argue that experienced
acquirers tend to do better than firms that make infrequent acquisitions.

684 Part 7 Special Topics in Financial Management

2. Will the acquisition strengthen the buyer’s core? Here they argue that com-
panies tend to do better when they acquire companies that operate in busi-
nesses they understand.

3. Did management do its homework? Successful acquirers take the time to do
the necessary due diligence.

4. Is the company addressing merger integration issues up front? Hardin and
Rovit point out that deals can often unravel because there isn’t a clear plan
for how the two management teams are going to be integrated following
the acquisition.

5. Is the executive team prepared for the unexpected? History shows that
nothing turns out the way it was planned. Successful acquirers anticipate the
unexpected and are able to adapt well to changing circumstances.

The early indications are that the P&G–Gillette merger has the potential to be
quite successful, but we will have to wait and see if the deal provides long-term
value to P&G shareholders.

Sources: Nikhil Deogun, Charles Forelle, Dennis K. Berman, and Emily Nelson, “Razor’s
Edge: P&G to Buy Gillette for $54 Billion—Deal Joins Iconic Giants of Consumer Prod-
ucts; 21 Billion-Dollar Brands—A Green Light for Takeovers,” The Wall Street Journal,
January 28, 2005, p. A1; A. G. Lafley and Patricia Sellers, “ ’It Was a No-Brainer’ That’s
What Procter & Gamble’s A. G. Lafley Says of His Decision to Buy Gillette. Here’s Why He
Thinks So—and How the Deal Came About,” Fortune, February 21, 2005, p. 96; Shawn
Tully, “The Urge to Merge With the Tally of High-Priced Mergers Growing by the Day,
One Can’t Help but Ask: Did We Learn Nothing from the Crash?” Fortune, February 21,
2005, p. 21; David Hardin and Sam Rovit, “Five Ways to Spot a Good Deal,” The Wall
Street Journal, March 29, 2005, p. B2; Dennis K. Berman, “Stock Market Quarterly Review:
Wave of Megamergers Keeps Rolling On—Big Companies Look to Deals for Spurring
Profit Growth; Private Equity’s Brief Pause,” The Wall Street Journal, April 1, 2005, p.
C13; and Robert Barker, “P&G’s $57 Billion Bargain,” BusinessWeek, July 25, 2005, p. 26.

Putting Things In Perspective

Most corporate growth occurs by internal expansion, which takes place when
a firm’s existing divisions grow through normal capital budgeting activities.
However, the most dramatic examples of growth, and often the largest
increases in firms’ stock prices, result from mergers, the first topic covered in
this chapter. Leveraged buyouts, or LBOs, occur when a firm’s stock is
acquired by a small group of investors rather than by another operating com-
pany. Because LBOs are similar to mergers in many respects, they are also
covered in this chapter. Conditions change over time, causing firms to sell off,
or divest, major divisions to other firms that can better utilize the divested
assets. We also discuss divestitures in the chapter. We leave the discussion of
the holding company form of organization, wherein one corporation owns the
stock of one or more other companies, for Web Appendix 21A.

Chapter 21 Mergers and Acquisitions 685

21.1 RATIONALE FOR MERGERS Merger
The combination of
Many reasons have been proposed by financial managers and theorists to two firms to form a
account for the high level of U.S. merger activity. The primary motives behind single firm.
corporate mergers are presented in this section.1
Synergy
Synergy The condition wherein
the whole is greater
The primary motivation for most mergers is to increase the value of the com- than the sum of its
bined enterprise. If Companies A and B merge to form Company C, and if C’s parts; in a synergistic
value exceeds that of A and B taken separately, then synergy is said to exist. merger, the post-
Such a merger should be beneficial to both A’s and B’s stockholders.2 Synergistic merger value exceeds
effects can arise from four sources: (1) operating economies, which result from eco- the sum of the
nomies of scale in management, marketing, production, or distribution; (2) finan- separate companies’
cial economies, including lower transactions costs and better coverage by security pre-merger values.
analysts; (3) differential efficiency, which implies that the management of one firm
is more efficient and that the weaker firm’s assets will be more productive after
the merger; and (4) increased market power due to reduced competition. Operating
and financial economies are socially desirable, as are mergers that increase man-
agerial efficiency, but mergers that reduce competition are socially undesirable
and often illegal.3

Tax Considerations

Tax considerations have stimulated a number of mergers. For example, a prof-
itable firm in the highest tax bracket could acquire a firm with large accumu-
lated tax losses. These losses could then be turned into immediate tax savings
rather than carried forward and used in the future.4 Also, mergers can serve as a
way of minimizing taxes when disposing of excess cash. For example, if a firm
has a shortage of internal investment opportunities compared with its free cash
flow, it could (1) pay an extra dividend, (2) invest in marketable securities, (3) re-
purchase its own stock, or (4) purchase another firm. If it pays an extra divi-
dend, its stockholders would have to pay immediate taxes on the distribution.
Marketable securities often provide a good temporary parking place for money,
but they generally earn a rate of return less than that required by stockholders.
A stock repurchase might result in a capital gain for the remaining stockholders.
However, using surplus cash to acquire another firm would avoid all these prob-
lems, and this has motivated a number of mergers.

1 As we use the term, merger means any combination that forms one economic unit from two or
more previous ones. For legal purposes, there are distinctions among the various ways these combi-
nations can occur, but our focus is on the fundamental economic and financial aspects of mergers.
2 If synergy exists, then the whole is greater than the sum of the parts. Synergy is also called the “2
plus 2 equals 5 effect.” The distribution of the synergistic gain between A’s and B’s stockholders is
determined by negotiation. This point is discussed later in the chapter.
3 In the 1880s and 1890s, many mergers occurred in the United States, and some of them were obvi-
ously directed toward gaining market power rather than increasing efficiency. As a result, Congress
passed a series of acts designed to ensure that mergers are not used as a method of reducing com-
petition. The principal acts include the Sherman Act (1890), the Clayton Act (1914), and the Celler
Act (1950). These acts make it illegal for firms to combine if the combination tends to lessen compe-
tition. The acts are enforced by the antitrust division of the Justice Department and by the Federal
Trade Commission.
4 Mergers undertaken only to use accumulated tax losses would probably be challenged by the IRS.
In recent years Congress has made it increasingly difficult for firms to pass along tax savings after
mergers.

686 Part 7 Special Topics in Financial Management

Defensive Merger Purchase of Assets below Their Replacement Cost

A merger designed to Sometimes a firm will be touted as an acquisition candidate because the cost of
make a company less replacing its assets is considerably higher than its market value. For example, in
vulnerable to a the early 1980s oil companies could acquire reserves cheaper by buying other oil
takeover. companies than by doing exploratory drilling. Thus, Chevron acquired Gulf Oil
to augment its reserves. Similarly, in the 1980s several steel company executives
stated that it was cheaper to buy an existing steel company than to construct a
new mill. For example, LTV (the fourth largest steel company) acquired Republic
Steel (the sixth largest) to create the second largest firm in the industry.

Diversification

Managers often cite diversification as a reason for mergers. They contend that
diversification helps stabilize a firm’s earnings and thus benefits its owners. Stabi-
lization of earnings is certainly beneficial to employees, suppliers, and customers,
but its value is less certain from the standpoint of stockholders. Why should Firm
A acquire Firm B to stabilize earnings when stockholders can simply buy the stock
of both firms? Indeed, research of U.S. firms suggests that in most cases diversifica-
tion does not increase the firm’s value. To the contrary, many studies find that
diversified firms are worth significantly less than the sum of their individual parts.5

Of course, if you were the owner-manager of a closely held firm, it might be
nearly impossible to sell part of your stock to diversify. Also, selling your stock
would probably lead to a large capital gains tax. So, a diversification merger
might be the best way to achieve personal diversification.

Managers’ Personal Incentives

Financial economists like to think that business decisions are based only on eco-
nomic considerations, especially maximization of firms’ values. However, many
business decisions are based more on managers’ personal motivations than on
economic analyses. Business leaders like power, and more power is attached to
running a larger corporation than a smaller one. Obviously, no executive would
admit that his or her ego was the primary reason behind a merger, but egos do
play a prominent role in many mergers.

It has also been observed that executive salaries are highly correlated with
company size—the bigger the company, the higher the salaries of its top officers.
This too could play a role in corporate acquisition programs.

Personal considerations deter as well as motivate mergers. After most
takeovers, some managers of the acquired companies lose their jobs, or at least
their autonomy. Therefore, managers who own less than 51 percent of their
firms’ stock look to devices that will lessen the chances of a takeover. Mergers
can serve as such a device. For example, several years ago Paramount made a
bid to acquire Time Inc. Time’s managers received a lot of criticism when they
rejected Paramount’s bid and chose instead to enter into a heavily debt-financed
merger with Warner Brothers that enabled them to retain power. Such defensive
mergers are hard to defend on economic grounds. The managers involved
invariably argue that synergy, not a desire to protect their own jobs, motivated
the acquisition, but observers suspect that many mergers were designed more to
benefit managers than stockholders.

5 See, for example, Philip Berger and Eli Ofek, “Diversification’s Effect on Firm Value,” Journal of
Financial Economics, Vol. 37 (1995), pp. 37–65; and Larry Lang and René Stulz, “Tobin’s Q, Corporate
Diversification, and Firm Performance,” Journal of Political Economy, Vol. 102 (1994), pp. 1248–1280.

Chapter 21 Mergers and Acquisitions 687

Breakup Value

Firms can be valued by book value, economic value, or replacement value.
Recently, takeover specialists have begun to recognize breakup value as another
basis for valuation. Analysts estimate a company’s breakup value, which is the
value of the individual parts of the firm if they were sold off separately. If this
value is higher than the firm’s current market value, then a takeover specialist
could acquire the firm at or even above its current market value, sell it off in
pieces, and earn a substantial profit.

Define synergy. Is synergy a valid rationale for mergers? Describe
several situations that might produce synergistic gains.

Give two examples of how tax considerations can motivate mergers.

Suppose your firm could purchase another firm for only half of its
replacement value. Would that be a sufficient justification for the
acquisition?

Discuss the pros and cons of diversification as a rationale for mergers.

What is breakup value?

21.2 TYPES OF MERGERS Horizontal Merger
A combination of two
Economists classify mergers into four types: (1) horizontal, (2) vertical, (3) con- firms that produce the
generic, and (4) conglomerate. A horizontal merger occurs when one firm com- same type of good or
bines with another in its same line of business—the NationsBank/BankAmerica service.
merger is an example. An example of a vertical merger would be a steel pro-
ducer’s acquisition of one of its own suppliers, such as an iron or coal mining Vertical Merger
firm, or an oil producer’s acquisition of a petrochemical firm that uses oil as a A merger between a
raw material. Congeneric means “allied in nature or action,” hence a congen- firm and one of its
eric merger involves related enterprises but not producers of the same product suppliers or customers.
(horizontal) or firms in a producer-supplier relationship (vertical). The Citi-
corp/Travelers merger is an example. A conglomerate merger occurs when unre- Congeneric Merger
lated enterprises combine, as illustrated by Mobil Oil’s acquisition of Montgomery A merger of firms in
Ward. the same general
industry, but for which
Operating economies (and also anticompetitive effects) are at least partially no customer or sup-
dependent on the type of merger involved. Vertical and horizontal mergers gen- plier relationship exists.
erally provide the greatest synergistic operating benefits, but they are also the
ones most likely to be attacked by the Department of Justice as anticompetitive. Conglomerate Merger
In any event, it is useful to think of these economic classifications when analyzing A merger of companies
prospective mergers. in totally different
industries.
What are the four economic types of mergers?

21.3 LEVEL OF MERGER ACTIVITY

Five major “merger waves” have occurred in the United States. The first was in
the late 1800s, when consolidations occurred in the oil, steel, tobacco, and other
basic industries. The second was in the 1920s, when the stock market boom

688 Part 7 Special Topics in Financial Management

helped financial promoters consolidate firms in a number of industries, includ-
ing utilities, communications, and autos. The third was in the 1960s, when con-
glomerate mergers were the rage. The fourth occurred in the 1980s, when LBO
firms and others began using junk bonds to finance all manner of acquisitions.
The fifth, which involves strategic alliances designed to enable firms to compete
better in the global economy, is in progress today.

As can be seen from Table 21-1, which lists some of the more recent larger
mergers, some huge mergers have occurred in recent years.6 In addition, there
have been a number of high-profile global mergers recently, including the
mergers of Daimler-Benz and Chrysler, Deutschebank and Bankers Trust, and
British Petroleum and Amoco. In general, these mergers have been significantly
different from those of the 1980s. Most 1980s mergers were financial transactions
in which buyers sought companies that were selling at less than their true values
as a result of incompetent or sluggish management. If a target company could be
managed better, if redundant assets could be sold, and if operating and adminis-
trative costs could be cut, profits and stock prices would rise. On the other hand,
most of the mergers have been strategic in nature—companies are merging to
gain economies of scale or scope and thus to be better able to compete in the
world economy. Indeed, many recent mergers have involved companies in the
financial, defense, media, computer, telecommunications, and health care indus-
tries, all of which are experiencing structural changes and intense competition.

Recently, there has also been an increase in cross-border mergers. Many of
these mergers have been motivated by large shifts in the value of the world’s

TA B L E 2 1 - 1 A Sample of Large Mergers Announced in Recent Years

Buyer Target Announcement Date Value (Billions, U.S. $)

America Online Time Warner January 10, 2000 $160.0
Vodafone AirTouch Mannesmann November 14, 1999 148.6
Pfizer Warner-Lambert November 4, 1999 90.0
Exxon Mobil December 1, 1998 85.2
Bell Atlantic GTE July 28, 1998 85.0
SBC Communications Ameritech May 11, 1998 80.6
Vodafone AirTouch January 18, 1999 74.4
Royal Dutch Petroleum Shell Trans. & Trading October 28, 2004 74.3
British Petroleum Amoco August 11, 1998 61.7
AT&T MediaOne Group May 6, 1999 61.0
Sanofi-Synthelabo Aventis January 26, 2004 60.2
Pfizer Pharmacia Corporation July 15, 2002 60.0
JP Morgan Chase Bank One January 14, 2004 58.8
Procter & Gamble Gillette January 28, 2005 55.0
Comcast AT&T Broadband July 8, 2001 47.0

Source: Adapted from recent “Year-End Review” articles from The Wall Street Journal.

6 For detailed reviews of the 1980s merger wave, see Andrei Shleifer and Robert W. Vishny, “The
Takeover Wave of the 1980s,” Journal of Applied Corporate Finance, Fall 1991, pp. 49–56; Edmund
Faltermayer, “The Deal Decade: Verdict on the ’80s,” Fortune, August 26, 1991, pp. 58–70; and “The
Best and Worst Deals of the ’80s: What We Learned from All Those Mergers, Acquisitions, and
Takeovers,” BusinessWeek, January 15, 1990, pp. 52–57.

Chapter 21 Mergers and Acquisitions 689

leading currencies. For example, in the early 1990s, the dollar was weak relative
to the yen and the mark. The decline in the dollar made it easier for Japanese
and German acquirers to buy U.S. corporations.

What five major “merger waves” have occurred in the United States?
What are some reasons for the current wave?

21.4 HOSTILE VERSUS FRIENDLY Acquiring Company
A company that seeks
TAKEOVERS to acquire another firm.
Target Company
In the vast majority of merger situations, one firm (generally the larger of the A firm that another
two) simply decides to buy another company, negotiates a price with the man- company seeks to
agement of the target firm, and then acquires the target company. Occasionally, acquire.
the acquired firm will initiate the action, but it is much more common for a firm
to seek acquisitions than to seek to be acquired.7 Following convention, we call a Friendly Merger
company that seeks to acquire another firm the acquiring company and the one A merger whose terms
that it seeks to acquire the target company. are approved by the
managements of both
Once an acquiring company has identified a possible target, it must companies.
(1) establish a suitable price, or range of prices, and (2) tentatively set the terms Hostile Merger
of payment—will it offer cash, its own common stock, bonds, or some combina- A merger in which the
tion? Next, the acquiring firm’s managers must decide how to approach the target firm’s manage-
target company’s managers. If the acquiring firm has reason to believe that the ment resists acquisition.
target’s management will approve the merger, then it will simply propose a Tender Offer
merger and try to work out some suitable terms. If an agreement is reached, The offer of one firm to
then the two management groups will issue statements to their stockholders buy the stock of
indicating that they approve the merger, and the target firm’s management will another by going
recommend to its stockholders that they agree to the merger. Generally, the stock- directly to the stock-
holders are asked to tender (or send in) their shares to a designated financial insti- holders, frequently (but
tution, along with a signed power of attorney that transfers ownership of the not always) over the
shares to the acquiring firm. The target firm’s stockholders then receive the speci- opposition of the
fied payment, either common stock of the acquiring company (in which case the target company’s
target company’s stockholders become stockholders of the acquiring company), management.
cash, bonds, or some mix of cash and securities. This is a friendly merger.

Often, however, the target company’s management resists the merger. Per-
haps they feel that the price offered is too low, or perhaps they simply want to
keep their jobs. In either case, the acquiring firm’s offer is said to be hostile rather
than friendly, and the acquiring firm must make a direct appeal to the target
firm’s stockholders. In a hostile merger, the acquiring company will again make
a tender offer, and again it will ask the stockholders of the target firm to tender
their shares in exchange for the offered price. This time, though, the target firm’s
managers will urge stockholders not to tender their shares, generally stating that
the price offered (cash, bonds, or stocks in the acquiring firm) is too low.

While most mergers are friendly, recently there have been a number of inter-
esting cases in which high-profile firms have attempted hostile takeovers. For
example, Warner-Lambert tried to fight off a hostile bid by Pfizer; however, the

7 However, if a firm is in financial difficulty, if its managers are elderly and do not think that suit-
able replacements are on hand, or if it needs the support (often the capital) of a larger company,
then it may seek to be acquired. Thus, when a number of Texas, Ohio, and Maryland financial insti-
tutions were in trouble in the 1980s, they lobbied to get their state legislatures to pass laws that
would make it easier for them to be acquired. Out-of-state banks then moved in to help salvage the
situation and minimize depositor losses.

690 Part 7 Special Topics in Financial Management

merger was completed in 2000. Looking overseas, Olivetti successfully con-
ducted a hostile takeover of Telecom Italia, and in another telecommunications
merger Britain’s Vodafone AirTouch made a hostile bid for its German rival,
Mannesmann AG, which was successful.

What’s the difference between a hostile and a friendly merger?

Proxy Fight 21.5 MERGER REGULATION

An attempt to gain Prior to the mid-1960s, friendly acquisitions generally took place as simple
control of a firm by exchange-of-stock mergers, and a proxy fight was the primary weapon used in
soliciting stockholders hostile control battles. However, in the mid-1960s corporate raiders began to
to vote for a new operate differently. First, it took a long time to mount a proxy fight—raiders had
management team. to first request a list of the target company’s stockholders, be refused, and then
get a court order forcing management to turn over the list. During that time, the
target’s management could think through and then implement a strategy to fend
off the raider. As a result, management won most proxy fights.

Then raiders began saying to themselves, “If we could bring the decision to
a head quickly, before management can take countermeasures, that would
greatly increase our probability of success.” That led the raiders to turn from
proxy fights to tender offers, which had a much shorter response time. For
example, the stockholders of a company whose stock was selling for $20 might
be offered $27 per share and be given two weeks to accept. The raider, mean-
while, would have accumulated a substantial block of the shares in open market
purchases, and additional shares might have been purchased by institutional
friends of the raider who promised to tender their shares in exchange for the tip
that a raid was to occur.

Faced with a well-planned raid, managements were generally overwhelmed.
The stock might actually be worth more than the offered price, but management
simply did not have time to get this message across to stockholders or to find a
competing bidder. This situation seemed unfair, so Congress passed the Williams
Act in 1968. This law had two main objectives: (1) to regulate the way acquiring
firms can structure takeover offers and (2) to force acquiring firms to disclose
more information about their offers. Basically, Congress wanted to put target
managements in a better position to defend against hostile offers. Additionally,
Congress believed that shareholders needed easier access to information about
tender offers—including information on any securities that might be offered in
lieu of cash—in order to make rational tender-versus-don’t-tender decisions.

The Williams Act placed the following four restrictions on acquiring firms:

1. Acquirers must disclose their current holdings and future intentions within
10 days of amassing at least 5 percent of a company’s stock.

2. Acquirers must disclose the source of the funds to be used in the acquisition.
3. The target firm’s shareholders must be allowed at least 20 days to tender

their shares; that is, the offer must be “open” for at least 20 days.
4. If the acquiring firm increases the offer price during the 20-day open period,

all shareholders who tendered prior to the new offer must receive the higher
price.

In total, these restrictions were intended to reduce the acquiring firm’s ability
to surprise management and to stampede target shareholders into accepting
an inadequate offer. Prior to the Williams Act, offers were generally made on a

Chapter 21 Mergers and Acquisitions 691

first-come, first-served basis, and they were often accompanied by an implicit
threat to lower the bid price after 50 percent of the shares were in hand. The
legislation also gave the target more time to mount a defense, and it gave rival
bidders and white knights a chance to enter the fray and thus help a target’s
stockholders obtain a better price.

Many states have also passed laws designed to protect firms in their states
from hostile takeovers. At first, these laws focused on disclosure requirements,
but by the late 1970s several states had enacted takeover statutes so restrictive
that they virtually precluded hostile takeovers. In 1979, MITE Corporation, a
Delaware firm, made a hostile tender offer for Chicago Rivet and Machine Co., a
publicly held Illinois corporation. Chicago Rivet sought protection under the Illi-
nois Business Takeover Act. The constitutionality of the Illinois act was con-
tested, and the U.S. Supreme Court found the law unconstitutional. The court
ruled that the market for securities is a national market, and even though the
issuing firm was incorporated in Illinois, the state of Illinois could not regulate
interstate securities transactions.

The Illinois decision effectively eliminated the first generation of state merger
regulations. However, the states kept trying to protect their state-headquartered
companies, and in 1987 the U.S. Supreme Court upheld an Indiana law that rad-
ically changed the rules of the takeover game. Specifically, the Indiana law first
defined “control shares” as enough shares to give an investor 20 percent of the
vote. It went on to state that when an investor buys control shares, those shares
can be voted only after approval by a majority of “disinterested shareholders,”
defined as those who are neither officers nor inside directors of the company,
nor associates of the raider. The law also gives the buyer of control shares the
right to insist that a shareholders’ meeting be called within 50 days to decide
whether the shares may be voted. The Indiana law dealt a major blow to raiders,
mainly because it slows down the action. Delaware (the state in which most large
companies are incorporated) later passed a similar bill, as did New York and a
number of other important states.

The new state laws also have some features that protect target stockholders
from their own managers. Included are limits on the use of golden parachutes,
onerous debt-financing plans, and some types of takeover defenses. Since these
laws do not regulate tender offers per se, but rather govern the practices of firms
in the state, they have withstood all legal challenges to date.

Is there a need to regulate mergers? Explain.

Do the states play a role in merger regulation, or is it all done at the
national level? Explain.

21.6 MERGER ANALYSIS

In theory, merger analysis is quite simple. The acquiring firm simply performs
an analysis to value the target company and then determines whether the tar-
get can be bought at that value or, preferably, for less than the estimated
value. The target company, on the other hand, should accept the offer if the
price exceeds either its value if it continued to operate independently or the
price it can receive from some other bidder. Theory aside, however, some diffi-
cult issues are involved. In this section, we first discuss valuing the target firm,
which is the initial step in a merger analysis. Then we discuss setting the bid
price and post-merger control.

Copyright 2007 Thomson Learning, Inc. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part.

692 Part 7 Special Topics in Financial Management

Financial Merger Valuing the Target Firm
A merger in which the
firms involved will not Several methodologies are used to value target firms, but we will confine our
be operated as a sin- discussion to the two most common: (1) the discounted cash flow approach and
gle unit and from (2) the market multiple method. However, regardless of the valuation methodol-
which no operating ogy, it is crucial to recognize two facts. First, the target company typically will
economies are not continue to operate as a separate entity but will become part of the acquiring
expected. firm’s portfolio of assets. Therefore, changes in operations will affect the value of
Operating Merger the business and must be considered in the analysis. Second, the goal of merger
A merger in which valuation is to value the target firm’s equity, because a firm is acquired from its
operations of the firms owners, not from its creditors. Thus, although we use the phrase “valuing the
involved are integrated firm,” our focus is on the value of the equity rather than on total value.
in hope of achieving
synergistic benefits. Discounted Cash Flow Analysis

Equity Residual The discounted cash flow (DCF) approach to valuing a business involves the appli-
Method cation of capital budgeting procedures to an entire firm rather than to a single proj-
A method used to ect. To apply this method, two key items are needed: (1) pro forma statements that
value a target firm forecast the incremental free cash flows expected to result from the merger and
using net cash flows (2) a discount rate, or cost of capital, to apply to these projected cash flows.
that are a residual and
belong solely to the Pro Forma Cash Flow Statements Obtaining accurate post-merger cash flow
acquiring firm’s share- forecasts is by far the most important task in the DCF approach. In a pure finan-
holders. cial merger, in which no synergies are expected, the incremental post-merger
cash flows are simply the expected cash flows of the target firm. In an operating
merger, where the two firms’ operations are to be integrated, forecasting future
cash flows is more difficult.

Table 21-2 shows the projected cash flow statements for Apex Corporation,
which is being considered as a target by Hightech, a large conglomerate. The
projected data are for the post-merger period, and all synergistic effects have
been included. Apex currently uses 50 percent debt, and if it were acquired,
Hightech would keep the debt ratio at 50 percent. Both Hightech and Apex have
a 40 percent marginal federal-plus-state tax rate.

Lines 1 through 4 of the table show the operating information that Hightech
expects for the Apex subsidiary if the merger takes place, and Line 5 contains
the earnings before interest and taxes (EBIT) for each year. Unlike a typical capi-
tal budgeting analysis, a merger analysis usually does incorporate interest
expense into the cash flow forecast, as shown on Line 6. This is done for three
reasons: (1) Acquiring firms often assume the debt of the target firm, so old debt
at different coupon rates is often part of the deal; (2) the acquisition is often
financed partially by debt; and (3) if the subsidiary is to grow in the future, new
debt will have to be issued over time to support the expansion. Thus, debt asso-
ciated with a merger is typically more complex than the single issue of new debt
associated with a normal capital project, and the easiest way to properly account
for the complexities of merger debt is to specifically include each year’s
expected interest expense in the cash flow forecast. Therefore, we are using what
is called the equity residual method to value the target firm. Here the estimated
net cash flows are a residual that belongs solely to the acquiring firm’s share-
holders. Therefore, they should be discounted at the cost of equity. This is in
contrast to the corporate value model of Chapter 9, where the free cash flows
(which belong to all investors, not just shareholders) are discounted at the
WACC. Both methods lead to the same estimate of equity value.

Line 7 contains the earnings before taxes (EBT), and Line 8 gives taxes based
on Hightech’s 40 percent marginal rate. Line 9 lists each year’s net income, and
depreciation is added back on Line 10 to obtain each year’s cash flow as shown

Chapter 21 Mergers and Acquisitions 693

TABLE 21-2 Projected Post-Merger Cash Flow Statements for the Apex Subsidiary
as of December 31 (Millions of Dollars)

1. Net sales 2006 2007 2008 2009 2010
2. Cost of goods sold
3. Selling and administrative expenses $105.0 $126.0 $151.0 $174.0 $191.0
4. Depreciation 75.0 89.0 106.0 122.0 132.0
5. EBIT 10.0 12.0 13.0 15.0 16.0
6. Interesta 8.0 8.0 9.0 9.0 10.0
7. EBT
8. Taxes (40%)b $ 12.0 $ 17.0 $ 23.0 $ 28.0 $ 33.0
9. Net income 8.0 9.0 10.0 11.0 11.0
10. Plus depreciation
11. Cash flow $ 4.0 $ 8.0 $ 13.0 $ 17.0 $ 22.0
12. Less retentions needed for growthc 1.6 3.2 5.2 6.8 8.8
13. Plus terminal valued
14. Net cash flow to Highteche $ 2.4 $ 4.8 $ 7.8 $ 10.2 $ 13.2
8.0 8.0 9.0 9.0 10.0

$ 10.4 $ 12.8 $ 16.8 $ 19.2 $ 23.2
4.0 4.0 7.0 9.0 12.0

$ 6.4 $ 8.8 $ 9.8 $ 10.2 127.8
$139.0

Notes:
a Interest payments are estimates based on Apex’s existing debt, plus additional debt required to finance growth.
b Hightech will file a consolidated tax return after the merger. Thus, the taxes shown here are the full corporate taxes attributable to
Apex’s operations: there will be no additional taxes on any cash flows passed from Apex to Hightech.
c Some of the cash flows generated by the Apex subsidiary after the merger must be retained to finance asset replacements and
growth, while some will be transferred to Hightech to pay dividends on its stock or for redeployment within the corporation. These
retentions are net of any additional debt used to help finance growth.
d Apex’s available cash flows are expected to grow at a constant 5 percent rate after 2010. The value of all post-2010 cash flows as of
December 31, 2010, is estimated by use of the constant growth model to be $127.8 million.

V2010 ϭ CF2011 ϭ 123.2 Ϫ $12.02 11.052 ϭ $127.8 million
rs Ϫ g 0.142 Ϫ 0.05

In the next section, we discuss the estimated 14.2 percent cost of equity. The $127.8 million is the PV at the end of 2010 of the stream
of cash flows for Year 2011 and thereafter.
e These are the net cash flows projected to be available to Hightech by virtue of the acquisition. The cash flows could be used for
dividend payments to Hightech’s stockholders, to finance asset expansion in Hightech’s other divisions and subsidiaries, and so on.

on Line 11. Because some of Apex’s assets will wear out or become obsolete, and
because Hightech plans to expand the Apex subsidiary should the acquisition
occur, some equity funds must be retained and reinvested in the business. These
retentions, which are not available for transfer to the parent, are shown on Line 12.
Finally, we have projected only five years of cash flows, but Hightech would
likely operate the Apex subsidiary for many years—in theory, forever. Therefore,
we applied the constant growth model to the 2010 cash flow to estimate the
value of all cash flows beyond 2010. (See Note d to Table 21-2.) This “terminal
value” represents Apex’s projected value at the end of 2010, and it is shown on
Line 13.

The net cash flows shown on Line 14 would be available to Hightech’s
stockholders, and they are the basis of the valuation.8 Of course, the post-merger

8 We purposely kept the cash flows relatively simple to help focus on key issues. In an actual
merger valuation, the cash flows would be much more complex, normally including such items as
additional capital furnished by the acquiring firm, tax loss carry-forwards, tax effects of plant and
equipment valuation adjustments, and cash flows from the sale of some of the subsidiary’s assets.

694 Part 7 Special Topics in Financial Management

cash flows are extremely difficult to estimate, and in a complete merger valua-
tion, just as in a complete capital budgeting analysis, sensitivity, scenario, and
simulation analyses should be conducted. Indeed, in a friendly merger the
acquiring firm would send a team consisting of literally dozens of accountants,
engineers, and so forth, to the target firm’s headquarters. They would go over its
books, estimate required maintenance expenditures, set values on assets such as
real estate and petroleum reserves, and the like. Such an investigation, which is
called due diligence, is an essential part of any merger analysis.

Estimating the Discount Rate The bottom-line net cash flows shown on Line
14 are after interest and taxes, hence they represent equity. Therefore, they
should be discounted at the cost of equity rather than at the overall cost of capi-
tal. Further, the discount rate used should reflect the risk of the cash flows in the
table. The most appropriate discount rate is Apex’s cost of equity, not that of
either Hightech or the consolidated post-merger firm.

Although we will not illustrate it here, Hightech could perform a risk analysis
on the Table 21-2 cash flows just as it does on any set of capital budgeting flows.
Sensitivity analysis, scenario analysis, and/or Monte Carlo simulation could be
used to give Hightech’s management a feel for the risks involved with the acqui-
sition. Apex is a publicly traded company, so we can assess directly its market
risk. Apex’s market-determined pre-merger beta was 1.63. Because the merger
would not change Apex’s capital structure or tax rate, its post-merger beta would
remain at 1.63. However, if Apex’s capital structure had changed, then the
Hamada equation (which was discussed in Chapter 14) could have been used to
determine the firm’s new beta corresponding to its changed capital structure.

We use the Security Market Line to estimate Apex’s post-merger cost of
equity. If the risk-free rate is 6 percent and the market risk premium is 5 percent,
then Apex’s cost of equity, rs, after the merger with Hightech, would be about
14.2 percent.9

rs ϭ rRF ϩ 1RPM 2 b ϭ 6% ϩ 15% 2 1.63 ϭ 14.15% Ϸ 14.2%

Valuing the Cash Flows The current value of Apex’s stock to Hightech is the
present value of the cash flows expected from Apex, discounted at 14.2 percent
(in millions of dollars):

V2005 ϭ $6.4 ϩ $8.8 ϩ $9.8 ϩ $10.2 ϩ $139.0 Ϸ $96.5
11.142 2 1 11.142 2 2 11.142 2 3 11.142 2 4 11.142 2 5

Thus, the value of Apex’s stock to Hightech is $96.5 million.
Note that in a merger analysis, the value of the target consists of the target’s

pre-merger value plus any value created by operating or financial synergies. In
this example, we held the target’s capital structure and tax rate constant. There-

9 In this example, we used the Capital Asset Pricing Model to estimate Apex’s cost of equity, and
thus we assumed that investors require a premium for market risk only. We could have also con-
ducted a corporate risk analysis, in which the relevant risk would be the contribution of Apex’s cash
flows to the total risk of the post-merger firm.

In actual merger situations among large firms, companies almost always hire an investment
banker to help develop valuation estimates. For example, when General Electric acquired Utah
International, GE hired Morgan Stanley to determine Utah’s value. We discussed the valuation
process with the Morgan Stanley analyst in charge of the appraisal, and he confirmed that they
applied all of the standard procedures discussed in this chapter. Note, though, that merger analysis,
like the analysis of any other complex issue, requires judgment, and people’s judgments differ as to
how much weight to give to different methods in any given situation.

Chapter 21 Mergers and Acquisitions 695

fore, the only synergies were operating synergies, and these effects were incor- Market Multiple
porated into the forecasted cash flows. If there had been financial synergies, the Analysis
analysis would have to be modified to reflect this added value. For example, if A method of valuing
Apex had been operating with only 30 percent debt, and if Hightech could lower a target company
Apex’s overall cost of capital by increasing the debt ratio to 50 percent, then Apex’s that applies a market-
merger value would have exceeded the $96.5 million calculated above. determined multiple to
net income, earnings
Market Multiple Analysis per share, sales, book
value, and so forth.
The second method of valuing a target company is market multiple analysis,
which applies a market-determined multiple to net income, earnings per share, A video clip entitled
sales, book value, or, for businesses such as cable TV or cellular telephone sys- “T. Boone Pickens on
tems, the number of subscribers. While the DCF method applies valuation con- White Knights,” which
cepts in a precise manner, focusing on expected cash flows, market multiple discusses mergers and
analysis is more judgmental. To illustrate the concept, note that Apex’s fore- takeovers, is available at
casted net income is $2.4 million in 2006, and it rises to $13.2 million in 2010, for Ohio State University’s
an average of $7.7 million over the five-year forecast period. The average P/E Web site at http://www
ratio for publicly traded companies similar to Apex is 12.5. .cob.ohio-state.edu/~fin/
clips.htm. The clip
To estimate Apex’s value using the market P/E multiple approach, simply requires a QuickTime
multiply its $7.7 million average net income by the market multiple of 12.5 to video player for either
obtain the value of $7.7(12.5) ϭ $96.25 million. This is the equity, or ownership, Windows or Macintosh
value of the firm. Note that we used the average net income over the next five machines (which you
years to value Apex. The market P/E multiple of 12.5 is based on the current download for free over
year’s income of comparable companies, but Apex’s current income does not the Internet at http://www
reflect synergistic effects or managerial changes that will be made. By averaging .apple.com/quicktime/).
future net income, we are attempting to capture the value added by Hightech to One caveat is that the
Apex’s operations. video clip is in excess of
5 MB in size and should
Note that measures other than net income can be used in the market multi- therefore only be
ple approach. For example, another commonly used measure is earnings before accessed with a rapid
interest, taxes, depreciation, and amortization (EBITDA). The procedure would be Internet connection.
identical to that just described, except that the market multiple would be price
divided by EBITDA rather than earnings per share, and this multiple would be
multiplied by Apex’s EBITDA.

As noted, in some businesses such as cable TV and cellular telephone, an
important element in the valuation process is the number of customers a com-
pany has. The acquirer has an idea of the cost required to obtain a new customer
and the average cash flow per customer. Managed care companies such as
HMOs have applied similar logic in acquisitions, basing their valuations on the
number of people insured.

Setting the Bid Price

Using the DCF valuation results, $96.5 million is the most Hightech could pay
for Apex—if it pays more, then Hightech’s own value will be diluted. On the
other hand, if Hightech can acquire Apex for less than $96.5 million, Hightech’s
stockholders will gain value. Therefore, Hightech will bid something less than
$96.5 million when it makes an offer for Apex.

Figure 21-1 graphs the merger situation. The $96.5 million is shown as a
point on the horizontal axis, and it is the maximum price that Hightech can
afford to pay. If Hightech pays less, say, $86.5 million, then its stockholders will
gain $10 million from the merger, while if it pays more, its stockholders will
lose. What we have, then, is a 45-degree line that cuts the X-axis at $96.5 million,
and that line shows how much Hightech’s stockholders can expect to gain or
lose at different acquisition prices.

696 Part 7 Special Topics in Financial Management

F I G U R E 2 1 - 1 A View of Merger Analysis (Millions of Dollars)

Change in
Stockholders'

Wealth
($)

Hightech (Acquirer) Apex (Target)

0

$62.5 $96.5 Price Paid for
Target ($)

Bargaining Range
= Synergy

Now consider the target company, Apex. It has 10 million shares of stock
that sell for $6.25, so its value as an independent operating company is presum-
ably $62.5 million. [In making this statement, we assume (1) that the company
is being operated as well as possible by its present management and (2) that
the $6.25 market price per share does not include a “speculative merger pre-
mium” in addition to the PV of its operating cash flows.] If Apex is acquired at
a price greater than $62.5 million, its stockholders will gain value, while they
will lose value at any lower price. Thus, we can draw another 45-degree line,
this one with an upward slope, to show how the merger price affects Apex’s
stockholders.

The difference between $62.5 and $96.5 million, or $34 million, represents
synergistic benefits expected from the merger. Here are some points to note:

1. If there were no synergistic benefits, the maximum bid would be equal to
the current value of the target company. The greater the synergistic gains, the
greater the gap between the target’s current price and the maximum the
acquiring company could pay.

2. The greater the synergistic gains, the more likely a merger is to be consum-
mated.

3. The issue of how to divide the synergistic benefits is critically important.
Obviously, both parties will want to get as much as possible. In our example,
if Apex’s management knew the maximum price that Hightech could pay, it
would argue for a price close to $96.5 million. Hightech, on the other hand,
would try to get Apex at a price as close to $62.5 million as possible.

4. Where, within the $62.5 to $96.5 million range, will the actual price be set?
The answer depends on a number of factors, including whether Hightech

Chapter 21 Mergers and Acquisitions 697

More Than Just Financial
Statements

When corporations merge, they combine more than the importance of these issues as follows: “Even
just their financial statements. Mergers bring together transactions that make absolute economic sense
two organizations with different histories and corpo- don’t happen unless the social issues work.”
rate cultures. Deals that look good on paper can fail if
the individuals involved are unwilling or unable to Investment bankers, lawyers, and other profes-
work together to generate the potential synergies. sionals state that mergers tend to be most successful
Consequently, when analyzing a potential merger, it is if there is a clear and well-arranged plan spelling out
important to determine whether the two companies who will run the company. This issue is straightforward
are compatible. if one firm is clearly dominant and is acquiring the
other. However, in cases where there is “a merger of
Many deals fall apart because, during the “due equals,” senior personnel issues often become sticky.
diligence” phase, synergistic benefits are revealed to This situation is made considerably easier if one of the
be less than was originally anticipated, so there is lit- chief executives is at or near the retirement age.
tle economic rationale for the merger. Other negotia-
tions break off because the two parties cannot agree Some analysts believe that social issues often
on the price to be paid for the acquired firm’s stock. play too large a role, derailing mergers that should
In addition, merger talks often collapse because of take place. In other cases where a merger occurs,
“social issues.” These social issues include both the concerns about social issues preclude managers from
“chemistry” of the companies and their personnel undertaking the necessary changes—like laying off
and such basic issues as these: What will be the redundant staff—for the deal to benefit shareholders.
name of the combined company? Where will head-
quarters be located? And, most important: Who will Source: “In Many Merger Deals, Ego and Pride Play Big Roles
run the combined company? Robert Kindler, a part- in Which Way Talks Go,” The Wall Street Journal, August 22,
ner at Cravath, Swaine & Moore, a prominent New 1996, p. C1. Reprinted by permission of The Wall Street Jour-
York law firm that specializes in mergers, summarizes nal, Copyright © 2002 Dow Jones & Company, Inc. All Rights
Reserved Worldwide.

offers to pay with cash or securities, the negotiating skills of the two man-
agement teams, and, most importantly, the bargaining positions of the two
parties as determined by fundamental economic conditions. To illustrate the
latter point, suppose there are many companies similar to Apex that High-
tech could acquire, but no company other than Hightech that could gain syn-
ergies by acquiring Apex. In this case, Hightech would probably make a rela-
tively low, take-it-or-leave-it offer, and Apex would probably take it because
some gain is better than none. On the other hand, if Apex has some unique
technology or other asset that many companies want, then once Hightech
announces its offer, others will probably make competing bids, and the final
price will probably be close to or even above $96.5 million. A price above
$96.5 million would presumably be paid by some other company that had a
better synergistic fit or, perhaps, whose management was more optimistic
about Apex’s cash flow potential. In Figure 21-1, this situation would be rep-
resented by a line parallel to that for Hightech but shifted to the right of the
Hightech line.
5. Hightech would, of course, want to keep its maximum bid secret, and it
would plan its bidding strategy carefully and consistently with the situation.
If it thought that other bidders would emerge, or that Apex’s management

698 Part 7 Special Topics in Financial Management

might resist in order to preserve their jobs, it might make a high “preemp-
tive” bid in hopes of scaring off competing bids and/or management resis-
tance. On the other hand, it might make a low-ball bid in hopes of “stealing”
the company.

We will have more to say about these points in the sections that follow, and you
should keep Figure 21-1 in mind as you go through the rest of the chapter.

Post-Merger Control

The employment/control situation is often of vital interest in a merger analysis.
First, consider the situation in which a small, owner-managed firm sells out to a
larger concern. The owner-manager may be anxious to retain a high-status posi-
tion, and he or she may also have developed a camaraderie with the employees
and thus be concerned about their retention after the merger. If so, these points
would be stressed during the merger negotiations.10 When a publicly owned firm
that is not owned by its managers is merged into another company, the acquired
firm’s managers will be worried about their post-merger positions. If the acquir-
ing firm agrees to retain the old management, then management may be willing
to support the merger and to recommend its acceptance to the stockholders. If
the old management is to be removed, then it will probably resist the merger.11

What is the difference between an operating merger and a financial
merger?

Describe the way post-merger cash flows are estimated in a DCF
analysis.

What is the basis for the discount rate in a DCF analysis? Describe
how this rate might be estimated.

Describe the market multiple approach.

What are some factors that acquiring firms consider when they set a
bid price?

How do control issues affect mergers?

10 The acquiring firm may also be concerned about this point, especially if the target firm’s manage-
ment is quite good. Indeed, a condition of the merger may be that the management team agree to
stay on for a period such as five years after the merger. In this case, the price paid may be contin-
gent on the acquired firm’s performance subsequent to the merger. For example, when International
Holdings acquired Walker Products, the price paid was an immediate 100,000 shares of Interna-
tional Holdings stock worth $63 per share plus an additional 30,000 shares each year for the next
three years, provided Walker Products earned at least $1 million during each of these years. Since
Walker’s managers owned the stock and would receive the bonus, they had a strong incentive to
stay on and help the firm meet its targets.

Finally, if the managers of the target company are highly competent but do not wish to remain
on after the merger, the acquiring firm may build into the merger contract a noncompete agreement
with the old management. Typically, the acquired firm’s principal officers must agree not to affiliate
with a new business that is competitive with the one they sold for a specified period, say, five years.
Such agreements are especially important with service-oriented businesses.
11 Managements of firms that are thought to be attractive merger candidates often arrange golden
parachutes for themselves. Golden parachutes are extremely lucrative retirement plans that take
effect if a merger is consummated. Thus, when Bendix Corp. was acquired by Allied Automotive,
Bill Agee, Bendix’s chairman, “pulled the ripcord of his golden parachute” and walked away with
$4 million. If a golden parachute is large enough, it can also function as a poison pill—for example,
where the president of a firm worth $10 million would have to be paid $8 million if the firm is
acquired, this will prevent a takeover. Stockholders are increasingly resisting such arrangements,
but some still exist.

Chapter 21 Mergers and Acquisitions 699

What is the value of XYZ Corporation to JKL Enterprises, assuming
the following facts? XYZ’s post-merger cash flows in Years 1–3 are
estimated to be $7 million, $10 million, and $12 million. In addition,
its terminal value in Year 3 is $318 million. The firm’s cost of equity
is 10 percent and its growth rate is 6 percent. ($262.56 million)

21.7 FINANCIAL REPORTING FOR MERGERS Purchase Accounting
A method of account-
Although a detailed discussion of financial reporting is best left to financial ing for a merger as a
accounting courses, the accounting implications of mergers cannot be ignored. purchase. In this
Currently, mergers are handled using purchase accounting.12 Keep in mind, method, the acquiring
however, that all larger companies are required to keep two sets of books. The firm is assumed to
first is for the IRS, and it reflects the tax treatment of mergers as described in have “bought” the
the previous section. The second is for financial reporting, and it reflects the acquired company in
treatment described below. The rules for financial reporting differ from those for much the same way it
the IRS.13 would buy any capital
asset.
Purchase Accounting
Goodwill
Table 21-3 illustrates purchase accounting. Here Firm A is assumed to have Refers to the excess
“bought” Firm B in much the same way it would buy any capital asset, paying paid for a firm above
for it with cash, debt, or stock of the acquiring company. If the price paid is the appraised value of
exactly equal to the acquired firm’s net asset value, which is defined as its total the physical and intan-
assets minus its liabilities, then the consolidated balance sheet will be the same gible assets purchased.
as if the two statements were merged. Normally, though, there is an important
difference. If the price paid exceeds the net asset value, then asset values will be
increased to reflect the price actually paid, whereas if the price paid is less than
the net asset value, then assets must be written down when preparing the con-
solidated balance sheet.

Note that Firm B’s net asset value is $30, which is also its reported common
equity value. This $30 book value could be equal to the market value (which is
determined by investors based on the firm’s earning power), but book value
could also be more or less than the market value. Three situations are considered
in Table 21-3. First, in Column 3 we assume that Firm A gives cash or stock
worth $20 for Firm B. Thus, B’s assets as reported on its balance sheet were over-
valued, and A pays less than B’s net asset value. The overvaluation could be in
either fixed or current assets; an appraisal would be made but we assume that it
is fixed assets that are overvalued. Accordingly, we reduce B’s fixed assets and
also its common equity by $10 before constructing the consolidated balance
sheet shown in Column 3. Next, in Column 4, we assume that A pays exactly the
net asset value for B. In this case, the financial statements are simply combined.

Finally, in Column 5 we assume that A pays more than the net asset value
for B: $50 is paid for $30 of net assets. This excess is assumed to be partly attrib-
utable to undervalued assets (land, buildings, machinery, and inventories), so to
reflect this undervaluation, current and fixed assets are each increased by $5. In
addition, we assume that $10 of the $20 excess of market value over book value
is due to a superior sales organization, or some other intangible factor, and we
post this excess as goodwill. B’s common equity is increased by $20, the sum of

12 In 2001, the Financial Accounting Standards Board (FASB) issued Statement 141, which eliminated
the use of pooling accounting.
13 For additional information, refer to Eugene F. Brigham and Phillip R. Daves, Intermediate Financial
Management, 8th edition (Mason, OH: Thomson/South-Western, 2004), Chapter 25.

700 Part 7 Special Topics in Financial Management

TA B L E 2 1 - 3 Accounting for Mergers: A Acquires B

Current assets Firm A Firm B $20 Paida POST-MERGER: FIRM A $50 Paida
Fixed assets (1) (2) (3) $30 Paida (5)
Goodwilld (4)
$ 50 $25 $ 75 $ 80c
Total assets 50 25 65b $ 75 80c
0 0 0 75 10d
Debt 0
Equity $100 $50 $140 $170
$150
Total claims $ 40 $20 $ 60 $ 60
60 30 80e $ 60 110f
90
$100 $50 $140 $170
$150

Notes:
a The price paid is the net asset value, that is, total assets minus debt.
b Here we assume that Firm B’s fixed assets are written down from $25 to $15 before constructing the consolidated balance sheet.
c Here we assume that Firm B’s current and fixed assets are both increased to $30.
d Goodwill refers to the excess paid for a firm above the appraised value of the physical assets purchased. Goodwill represents

payment both for intangibles such as patents and for “organization value” such as that associated with having an effective sales

force. Beginning in 2001, purchased goodwill such as this could not be amortized for financial statement reporting purposes.
e Firm B’s common equity is reduced by $10 prior to consolidation to reflect the fixed assets write-off.
f Firm B’s equity is increased to $50 to reflect the above-book purchase price.

the increases in current and fixed assets plus goodwill, and this markup is also
reflected in A’s post-merger equity account.14

Income Statement Effects

A merger can have a significant effect on reported profits. If asset values are
increased, as they often are under a purchase, this must be reflected in higher
depreciation charges (and also in a higher cost of goods sold if inventories are writ-
ten up). This, in turn, will further reduce reported profits. Prior to 2001, goodwill
was also amortized over its expected life. Now, however, goodwill is subject to an
“annual impairment test.” If the fair market value of the goodwill has declined
over the year, then the amount of the decline must be charged to earnings. If not,
then there is no charge, but gains in goodwill cannot be added to earnings.

Table 21-4 illustrates the income statement effects of the write-up of current
and fixed assets. We assume that A purchased B for $50, creating $10 of goodwill
and $10 of higher physical assets value. As Column 3 indicates, the assets
markups cause reported profits to be lower than the sum of the individual com-
panies’ reported profits.

The asset markup is also reflected in earnings per share. In our hypothetical
merger, we assume that nine shares exist in the consolidated firm. (Six of these
shares went to A’s stockholders, and three to B’s.) The merged company’s EPS is
$2.33 while the individual companies’ EPS is $2.40.

What is purchase accounting for mergers?

What is goodwill? What effect does goodwill have on the firm’s
balance sheet? On its income statement?

14 This example assumes that additional debt was not issued to help finance the acquisition. If the
acquisition were totally debt financed, the postmerger balance sheet would show increases in the
debt account rather than increases in the equity account. If it were financed by a mix of debt and
equity, both accounts would be changed.

Chapter 21 Mergers and Acquisitions 701

Tempest in a Teapot?

In 2001, amid a flurry of warnings and lobbying, the flows. However, it does affect the earnings that com-
Financial Accounting Standards Board (FASB) in its panies report to their shareholders. Firms that used
Statement 141 eliminated the use of pooling for to have large goodwill charges from past acquisitions
merger accounting, requiring that purchase account- saw their reported earnings increase, because they no
ing be used instead. Because the change would oth- longer have to amortize the remaining goodwill. Firms
erwise have required that all purchased goodwill be whose acquisitions have fared badly, such as Time
amortized, and reported earnings reduced, the FASB Warner, must make large write-downs. Executives
also issued Statement 142, which eliminated the reg- facing an earnings boost hoped, while executives
ular amortization of purchased goodwill, replacing it facing a write-down feared, that investors would not
with an “impairment test.” The impairment test see through these accounting changes. However, evi-
requires that companies evaluate annually their pur- dence suggests that investors realize that a
chased goodwill and write it down if its value has company’s assets have deteriorated long before the
declined. This impairment test resulted in Time War- write-down actually occurs, and they build this infor-
ner’s unprecedented 2002 write-down of $54 billion mation into the price of the stock. For example, Time
of goodwill associated with the AOL merger. Warner’s announcement of its $54 billion charge in
January 2002 resulted in only a blip in its stock price
So what exactly is the effect of the change? First at that time, even though the write-down totaled
and foremost, the change does nothing to the firm’s more than a third of its market value. The market rec-
actual cash flows. Purchased goodwill may still be ognized the decline in value months earlier, and by
amortized for federal income tax purposes, so the the time of the announcement Time Warner had
change does not affect the actual taxes a company already lost more than $100 billion in market value.
pays, nor does it affect the company’s operating cash

TA B L E 2 1 - 4 Income Statements Effects

PRE-MERGER POST-MERGER
Merged
Firm A Firm B (3)
(1) (2)
$150.0
Sales $100.0 $50.0 109.0a
Operating costs 72.0 36.0
$ 41.0a
Operating income $ 28.0 $14.0 6.0
Interest (10%) 4.0 2.0
$ 35.0
Taxable income $ 24.0 $12.0 14.0
Taxes (40%) 9.6 4.8
$ 21.0
Net income $ 14.4 $ 7.2 $ 2.33
EPSb $ 2.40 $ 2.40

Notes:
a Operating costs are $1 higher than they otherwise would be to reflect the higher reported
costs (depreciation and cost of goods sold) caused by the physical assets markups at the time of
purchase.
b Firm A had six shares and Firm B had three shares before the merger. A gives one of its shares
for each of Bs, so A has nine shares after the merger.

702 Part 7 Special Topics in Financial Management

White Knight 21.8 THE ROLE OF INVESTMENT BANKERS
A company that is
acceptable to the man- Investment bankers are involved with mergers in a number of ways: (1) they help
agement of a firm arrange mergers, (2) they help target companies develop and implement defen-
under threat of a hos- sive tactics, (3) they help value target companies, (4) they help finance mergers,
tile takeover and that and (5) they invest in the stocks of potential merger candidates. These merger-
will compete with the related activities have been quite profitable. For example, Thomson Financial
potential acquirer. estimated that financial advisors received more than $13 billion in fees from
worldwide merger activity generated during just the first half of 2005. No won-
White Squire der investment banking houses are able to make top offers to finance graduates!
An individual or com-
pany who is friendly to Arranging Mergers
current management
and will buy enough of The major investment banking firms have merger and acquisition groups that
the target firm’s shares operate within their corporate finance departments. (Corporate finance depart-
to block a hostile ments offer advice, as opposed to underwriting or brokerage services, to busi-
takeover. ness firms.) Members of these groups identify firms with excess cash that might
want to buy other firms, companies that might be willing to be bought, and
Poison Pill firms that might, for a number of reasons, be attractive to others. Also, if an oil
An action that will company, for instance, decided to expand into coal mining, then it might enlist
seriously hurt a com- the aid of an investment banker to help it acquire a coal company. Similarly, dis-
pany if it is acquired sident stockholders of firms with poor track records might work with invest-
by another. ment bankers to oust management by helping to arrange a merger. Investment
bankers are reported to have offered packages of financing to corporate raiders,
Golden Parachutes where the package includes both designing the securities to be used in the ten-
Large payments made der offer, plus lining up people and firms who will buy the target firm’s stock
to the managers of a now, and then tender it once the final offer is made.
target firm if it is
acquired. Investment bankers have occasionally taken illegal actions in the merger
arena. For example, they are reported to have parked stock—purchasing it for a
raider under a guaranteed buy-back agreement—to help the raider de facto
accumulate more than 5 percent of the target’s stock without disclosing the posi-
tion. People have gone to jail for this.

Developing Defensive Tactics

Target firms that do not want to be acquired generally enlist the help of an
investment banking firm, along with a law firm that specializes in mergers.
Defenses include such tactics as (1) changing the by-laws so that only one-third
of the directors are elected each year and/or so that a 75 percent approval (a
supermajority) versus a simple majority is required to approve a merger; (2) try-
ing to convince the target firm’s stockholders that the price being offered is too
low; (3) raising antitrust issues in the hope that the Justice Department will
intervene; (4) repurchasing stock in the open market in an effort to push the
price above that being offered by the potential acquirer; (5) getting a white
knight who is acceptable to the target firm’s management to compete with the
potential acquirer; (6) getting a white squire who is friendly to current manage-
ment to buy enough of the target firm’s shares to block the merger; and (7) tak-
ing a poison pill, as described next.

Poison pills—which occasionally really do amount to committing economic
suicide to avoid a takeover—are such tactics as borrowing on terms that require
immediate repayment of all loans if the firm is acquired, selling off at bargain
prices the assets that originally made the firm a desirable target, granting such
lucrative golden parachutes to their executives that the cash drain from these
payments would render the merger infeasible, and planning defensive mergers
which would leave the firm with new assets of questionable value and a huge

Chapter 21 Mergers and Acquisitions 703

debt load. Currently, the most popular poison pill is for a company to give its
stockholders stock purchase rights that allow them to buy at half-price the stock
of an acquiring firm, should the firm be acquired. The blatant use of poison pills
is constrained by directors’ awareness that excessive use could trigger personal
suits by stockholders against directors who voted for them, and, perhaps in the
near future, by laws that would further limit management’s use of pills. Still,
investment bankers and antitakeover lawyers are busy thinking up new poison
pill formulas, and others are just as busy trying to come up with antidotes.15

Another takeover defense that is being used is the employee stock owner-
ship plan (ESOP). ESOPs are designed to give lower-level employees an owner-
ship stake in the firm, and current tax laws provide generous incentives for
companies to establish such plans and fund them with the firm’s common stock.

Establishing a Fair Value

If a friendly merger is being worked out between two firms’ managements, it is
important to document that the agreed-upon price is a fair one; otherwise, the
stockholders of either company may sue to block the merger. Therefore, in most
large mergers each side will hire an investment banking firm to evaluate the tar-
get company and to help establish the fair price. For example, General Electric
employed Morgan Stanley to determine a fair price for Utah International, as
did Royal Dutch to help establish the price it paid for Shell Oil. Even if the
merger is not friendly, investment bankers may still be asked to help establish a
price. If a surprise tender offer is to be made, the acquiring firm will want to
know the lowest price at which it might be able to acquire the stock, while the
target firm may seek help in “proving” that the price being offered is too low.16

Financing Mergers

Many mergers are financed with the acquiring company’s excess cash. However,
if the acquiring company has no excess cash, it will require a source of funds.
Perhaps the single most important factor behind the 1980s merger wave was the
development of junk bonds for use in financing acquisitions.

Drexel Burnham Lambert was the primary developer of junk bonds, defined
as bonds rated below investment grade (BBB/Baa). Prior to Drexel’s actions, it
was almost impossible to sell low-grade bonds to raise new capital. Drexel then
pioneered a procedure under which a target firm’s situation would be appraised
very closely, and a cash flow projection similar to that in Table 21-2 (but much
more detailed) would be developed.

To be successful in the mergers and acquisitions (M&A) business, an invest-
ment banker must be able to offer a financing package to clients, whether they
are acquirers who need capital to take over companies or target companies trying

15 It has become extremely difficult and expensive for companies to buy “directors’ insurance,” which
protects the board from such contingencies as stockholders’ suits, and even when insurance is avail-
able it often does not pay for losses if the directors have not exercised due caution and judgment.
This exposure is making directors extremely leery of actions that might trigger stockholder suits.
16 Such investigations must obviously be done in secret, for if someone knew that Company A was
thinking of offering, say, $50 per share for Company T, which was currently selling at $35 per share,
then huge profits could be made. One of the biggest scandals to hit Wall Street was the disclosure
that Ivan Boesky was buying information from Dennis Levine, a senior member of the investment
banking house of Drexel Burnham Lambert, about target companies that Drexel was analyzing for
others. Purchases based on such insider information would, of course, raise the prices of the stocks
and thus force Drexel’s clients to pay more than they otherwise would have had to pay. Levine and
Boesky, among others, went to jail for their improper use of insider information.

704 Part 7 Special Topics in Financial Management

Arbitrage to finance stock repurchase plans or other defenses against takeovers. Drexel
was the leading player in the merger financing game during the 1980s, but since
The simultaneous buy- Drexel’s bankruptcy Goldman Sachs, Merrill Lynch, UBS, Morgan Stanley, and
ing and selling of the others are all vying for the title.
same commodity or
security in two different Arbitrage Operations
markets at different
prices, and pocketing Arbitrage generally means simultaneously buying and selling the same com-
a risk-free return. modity or security in two different markets at different prices, and pocketing a
risk-free return. However, the major brokerage houses, as well as some wealthy
private investors, are engaged in a different type of arbitrage called risk arbitrage.
The arbitrageurs, or “arbs,” speculate in the stocks of companies that are likely
takeover targets. Vast amounts of capital are required to speculate in a large
number of securities and thus reduce risk, and also to make money on narrow
spreads. However, the large investment bankers have the wherewithal to play
the game. To be successful, arbs need to be able to sniff out likely targets, assess
the probability of offers reaching fruition, and move in and out of the market
quickly and with low transactions costs.

What are some defensive tactics that firms can use to resist hostile
takeovers?

What role did junk bonds play in the merger wave of the 1980s?

What is the difference between pure arbitrage and risk arbitrage?

21.9 DO MERGERS CREATE VALUE? THE

EMPIRICAL EVIDENCE

All the recent merger activity has raised two questions: (1) Do corporate acquisi-
tions create value? (2) If so, how is the value shared between the parties?

Most researchers agree that takeovers increase the wealth of the shareholders
of target firms, for otherwise they would not agree to the offer. However, there is
a debate as to whether mergers benefit the acquiring firm’s shareholders. In par-
ticular, managements of acquiring firms may be motivated by factors other than
shareholder wealth maximization. For example, they may want to merge merely
to increase the size of the corporations they manage, because increased size usu-
ally brings larger salaries plus job security, perquisites, power, and prestige.

The validity of the competing views on who gains from corporate acquisi-
tions can be tested by examining the stock price changes that occur around the
time of a merger or takeover announcement. Changes in the stock prices of the
acquiring and target firms represent market participants’ beliefs about the value
created by the merger, and about how that value will be divided between the
target and acquiring firms’ shareholders. So, examining a large sample of stock
price movements can shed light on the issue of who gains from mergers.

We cannot simply examine stock prices around merger announcement dates,
because other factors influence stock prices. For example, if a merger was
announced on a day when the entire market advanced, the fact that the target
firm’s price rose would not necessarily signify that the merger was expected to
create value. Hence, studies examine abnormal returns associated with merger
announcements, where abnormal returns are defined as that part of a stock price
change caused by factors other than changes in the general stock market.

Chapter 21 Mergers and Acquisitions 705

The Track Record of Recent
Large Mergers

Academics have long known that acquiring firm’s 2. Management overestimated the synergies (cost
shareholders rarely reap the benefits of mergers. savings and revenue gains) that would result from
However, this important information never seemed to the merger.
make it up to the offices of corporate America’s deci-
sion makers; the 1990s saw bad deal after bad deal, 3. Management took too long to integrate opera-
with no apparent learning on the part of acquisitive tions between the merged companies. This irri-
executives. BusinessWeek published an analysis of tated customers and employees alike, and it
302 large mergers from 1995 to 2001, and it found postponed any gains from the integration.
that 61 percent of them led to losses by the acquir-
ing firms’ shareholders. Indeed, those losing share- 4. Some companies cut costs too deeply, at the
holders’ returns during the first post-merger year expense of maintaining sales and production
averaged 25 percentage points less than the returns infrastructures.
on other companies in their industry. The average
returns for all the merging companies, both winners The worst performance came from companies that
and losers, were 4.3 percent below industry averages paid for their acquisitions with stock. The best perfor-
and 9.2 percent below the S&P 500. The article cited mance, albeit a paltry 0.3 percent better than industry
four common mistakes: averages, came from companies that used cash for
their acquisitions. On the bright side, the shareholders
1. The acquiring firms often overpaid. Generally, of the companies that were acquired fared quite well,
the acquirers gave away all of the synergies from earning on average 19.3 percent more than their
the mergers to the acquired firms’ shareholders, industry peers, and all of those gains came in the
and then some. two weeks surrounding the merger announcement.

Source: David Henry, “Mergers: Why Most Big Deals Don’t
Pay Off,” BusinessWeek, October 14, 2002, pp. 60–70.

Many studies have examined both acquiring and target firms’ stock price
responses to mergers and tender offers.17 Jointly, these studies have covered
nearly every acquisition involving publicly traded firms from the early 1960s to the
present, and they are remarkably consistent in their results: On average, the stock
prices of target firms increase by about 30 percent in hostile tender offers, while in
friendly mergers the average increase is about 20 percent. However, for both hostile
and friendly deals, the stock prices of acquiring firms, on average, remain constant.
However, as the accompanying box entitled “The Track Record of Recent Large
Mergers” suggests, abnormal returns vary considerably among mergers, and it is
not unusual for acquiring firms to see their stock prices fall when mergers are
announced. On balance, the evidence indicates (1) that acquisitions do create value,
but (2) that shareholders of target firms reap virtually all the benefits.

In hindsight, these results are not too surprising. First, target firm’s share-
holders can always say no, so they are in the driver’s seat. Second, takeovers are
a competitive game, so if one potential acquiring firm does not offer full value
for a potential target, then another firm will generally jump in with a higher bid.
Finally, managements of acquiring firms might well be willing to give up all the
value created by the merger, because the merger would enhance the acquiring
managers’ personal positions without harming their shareholders.

17 For an excellent summary of the effects of mergers on value, see Michael C. Jensen and Richard S.
Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics,
April 1983, pp. 5–50.

706 Part 7 Special Topics in Financial Management

Corporate, or It has also been argued that acquisitions may increase shareholder wealth at
Strategic, Alliance the expense of bondholders—in particular, concern has been expressed that
A cooperative deal leveraged buyouts dilute the claims of bondholders. Specific instances can be
that stops short of a cited in which bonds were downgraded and bondholders did suffer losses,
merger. sometimes quite large ones, as a direct result of an acquisition. However, most
studies find no evidence to support the contention that bondholders, on average,
Joint Venture lose in corporate acquisitions.
A corporate alliance
in which two or more Explain how researchers can study the effects of mergers on share-
independent compa- holder wealth.
nies combine their
resources to achieve Do mergers create value? If so, who profits from this value?
a specific, limited
objective. Do the research results discussed in this section seem logical? Explain.

Leveraged Buyout 21.10 CORPORATE ALLIANCES
(LBO)
A situation in which a Mergers are one way for two companies to join forces, but many companies are
small group of striking cooperative deals, called corporate, or strategic, alliances, which stop
investors (which usually far short of merging. Whereas mergers combine all of the assets of the firms
includes the firm’s involved, as well as their ownership and managerial expertise, alliances allow
managers) borrows firms to create combinations that focus on specific business lines that offer the
heavily to buy all the most potential synergies. These alliances take many forms, from simple market-
shares of a company. ing agreements to joint ownership of worldwide operations.

One form of corporate alliance is the joint venture, in which parts of compa-
nies are joined to achieve specific, limited objectives.18 A joint venture is controlled
by a management team consisting of representatives of the two (or more) parent
companies. Joint ventures have been used often by U.S., Japanese, and European
firms to share technology and/or marketing expertise. For example, Whirlpool
announced a joint venture with the Dutch electronics giant Philips to produce
appliances under Philips’s brand names in five European countries. By joining
with their foreign counterparts, U.S. firms are attempting to gain a stronger
foothold in Europe. Although alliances are new to some firms, they are established
practices to others. For example, Corning Glass now obtains more than half of its
profits from 23 joint ventures, two-thirds of them with foreign companies repre-
senting almost all of Europe, as well as Japan, China, South Korea, and Australia.

What is the difference between a merger and a corporate alliance?

What is a joint venture? Give some reasons joint ventures may be
advantageous to the parties involved.

21.11 LEVERAGED BUYOUTS

In a leveraged buyout (LBO) a small group of investors, which usually includes
current management, acquires a firm in a transaction financed largely by debt.
The debt is serviced with funds generated by the acquired company’s operations
and, often, by the sale of some of its assets. Sometimes, the acquiring group

18 Cross-licensing, consortia, joint bidding, and franchising are still other ways for firms to combine
resources. For more information on joint ventures, see Sanford V. Berg, Jerome Duncan, and Phillip
Friedman, Joint Venture Strategies and Corporate Innovation (Cambridge, MA: Oelgeschlager, Gunn
and Hain, 1982).

Chapter 21 Mergers and Acquisitions 707

plans to run the acquired company for a number of years, boost its sales and
profits, and then take it public again as a stronger company. In other instances,
the LBO firm plans to sell off divisions to other firms that can gain synergies. In
either case, the acquiring group expects to make a substantial profit from the
LBO, but the inherent risks are great due to the heavy use of financial leverage.
To illustrate the profit potential, Kohlberg Kravis Roberts & Company (KKR), a
leading LBO specialist firm, averaged a spectacular 50 percent annual return on
its LBO investments during the 1980s. However, strong stock prices for target
firms have dampened the returns on LBO investments, so recent activity has
been slower than in its heyday of the 1980s.

What is an LBO?

What actions do companies typically take to meet the large debt
burdens resulting from LBOs?

21.12 DIVESTITURES Divestiture
The sale of some of a
Although corporations do more buying than selling of productive facilities, a company’s operating
good bit of selling does occur. In this section, we briefly discuss the major types assets.
of divestitures, after which we present some recent examples and rationales for
divestitures. Spin-Off
A divestiture in which
Types of Divestitures the stock of a sub-
sidiary is given to the
There are four types of divestitures: (1) sale of an operating unit to another firm, parent company’s
(2) setting up the business to be divested as a separate corporation and then stockholders.
“spinning it off” to the divesting firm’s stockholders, (3) following the steps for a
spin-off but selling only some of the shares, and (4) outright liquidation of assets. Carve-Out
A minority interest in a
Sale to another firm generally involves the sale of an entire division or unit, corporate subsidiary is
usually for cash but sometimes for stock of the acquiring firm. In a spin-off, the sold to new sharehold-
firm’s existing stockholders are given new stock representing separate ownership ers, so the parent gains
rights in the division that was divested. The division establishes its own board of new equity financing
directors and officers, and it becomes a separate company. The stockholders end yet retains control.
up owning shares of two firms instead of one, but no cash has been transferred.
In a carve-out, a minority interest in a corporate subsidiary is sold to new share- Liquidation
holders, so the parent gains new equity financing yet retains control. Finally, in a Occurs when the assets
liquidation the assets of a division are sold off piecemeal, rather than as an oper- of a division are sold
ating entity. To illustrate the different types of divestitures, we present in the next off piecemeal, rather
section some high-profit examples that have occurred over the past several years. than as an operating
entity.
Divestiture Illustrations

1. Pepsi spun off its fast-food business, which included Pizza Hut, Taco Bell,
and Kentucky Fried Chicken. The spun-off businesses now operate under the
name Tricon Global Restaurants. Pepsi originally acquired the chains because
it wanted to increase the distribution channels for its soft drinks. Over time,
however, Pepsi began to realize that the soft-drink and restaurant businesses
were quite different, and synergies between them were less than anticipated.
The spin-off is part of Pepsi’s attempt to once again focus on its core business.
However, Pepsi will try to maintain these distribution channels by signing
long-term contracts that ensure that Pepsi products will be sold exclusively
in each of the three spun-off chains.

708 Part 7 Special Topics in Financial Management

GLOBAL PERSPECTIVES

Governments Are Divesting
State-Owned Businesses to Spur
Economic Efficiency

In many countries governments have traditionally ally, the government-owned enterprise was granted
owned or controlled a number of key businesses. monopoly power to supply the service in question and
When Margaret Thatcher became prime minister of was subsidized in an effort to hold down costs to con-
Britain in 1979, she set out to reverse this trend, and sumers. However, economists have long argued that
soon her officials were devising methods for the gov- government operations are inherently less efficient
ernment to divest state-owned enterprises. Thatcher than are enterprises that are subject to competitive
coined the term “privatization” to describe the process pressures and whose managers are guided by the
of transferring productive operations and assets from profit motive. Thus, in recent years there have been
the public sector to the private sector. numerous privatizations in these important industries,
and as governments have sold their interests, compe-
The privatization momentum picked up in the tition has led to lower costs and improved service.
early and mid-1980s, expanding to other countries
including France, Germany, Japan, and Singapore. Pri- In Western Europe, privatizations in the telecom-
vatization accelerated further as the communist coun- munications industry have been given an extra push by
tries and authoritarian regimes across Eastern Europe, a European Union plan that opened markets to com-
Asia, and Latin America shifted toward market-based petition. Because most European telecoms were gov-
economies. ernment owned, the resulting privatizations brought
to market tens of billions of dollars of telecom stock.
Telecommunications, electric power, and airlines Globally, governments have raised hundreds of bil-
are examples of industries that have undergone exten- lions of dollars through privatizations.
sive privatization throughout the world. These indus-
tries are vitally important to the economic infrastruc- The results are not all in, but it is clear that the
ture of every nation, and for this reason governments removal of bureaucrats and politicians from the con-
have historically been heavily involved in owning and trol of key enterprises often results in increased eco-
regulating them within their national borders. Gener- nomic efficiency and a higher standard of living.

2. United Airlines sold its Hilton International Hotels subsidiary to Ladbroke
Group PLC of Britain for $1.1 billion and also sold its Hertz rental car unit
and its Westin hotel group. The sales culminated a disastrous strategic move
by United to build a full-service travel empire. The failed strategy resulted
in the firing of Richard J. Ferris, the company’s chairman. The move into
nonairline travel-related businesses had been viewed by many analysts as a
mistake, because there were few synergies to be gained. Further, analysts
feared that United’s managers, preoccupied by running hotels and rental car
companies, would not maintain the company’s focus in the highly competi-
tive airline industry. The funds raised by the divestitures were paid out to
United’s shareholders as a special dividend.

3. General Motors (GM) spun off its Electronic Data Systems (EDS) subsidiary.
EDS, a computer services company founded in 1962 by Ross Perot, prospered
as an independent company until it was acquired by GM in 1984. The rationale
for the acquisition was that EDS’s expertise would help GM both operate better
in the information age and build cars that encompassed leading-edge computer
technology. However, the spread of desktop computers and the movement of
companies to downsize their internal computer staffs caused EDS’s non-GM
business to soar. Ownership by GM hampered EDS’s ability to strike alliances
and, in some cases, to enter into business agreements. The best way for EDS
to compete in its industry was as an independent, hence it was spun off.

Chapter 21 Mergers and Acquisitions 709

4. AT&T was broken up in 1983 to settle a Justice Department antitrust suit
filed in the 1970s.19 For almost 100 years AT&T had operated as a holding
company that owned Western Electric (its manufacturing subsidiary), Bell
Labs (its research arm), a huge long-distance network that was operated as a
division of the parent company, and 22 Bell operating companies, such as
Pacific Telephone, New York Telephone, Southern Bell, and Southwestern
Bell. In 1984, AT&T was reorganized into eight separate companies—a
slimmed-down AT&T, which kept Western Electric, Bell Labs, and the long-
distance operations, plus seven new regional telephone holding companies
that were created from the 22 old operating telephone companies. The stock
of the seven new telephone companies was then spun off to the old AT&T’s
stockholders. A person who held 100 shares of old AT&T stock owned, after
the divestiture, 100 shares of the “new” AT&T plus 10 shares of each of the
seven new operating companies. These 170 shares were backed by the same
assets that had previously backed 100 shares of old AT&T common.
The AT&T divestiture resulted from a suit by the Justice Department,
which wanted to divide the Bell System into a regulated monopoly segment
(the seven regional telephone companies) and a manufacturing/long-distance
segment that would be exposed to competition. The breakup was designed
to strengthen competition and thus speed up technological change in those
parts of the telecommunications industry that are not natural monopolies.
Ironically, in 2005 SBC Communications, which can trace its roots back to the
original Bell Telephone Co., announced plans to acquire AT&T for $16 billion.
The merger is expected to take place in early 2006 and to result in a premier
global communications company.

5. Some years ago, Woolworth liquidated all of its 336 Woolco discount stores.
This made the company, which had had sales of $7.2 billion before the liqui-
dation, 30 percent smaller. Woolco had posted operating losses of $19 million
the year before the liquidation, and its losses in the latest six months had
climbed to an alarming $21 million. Woolworth’s CEO, Edward F. Gibbons,
was quoted as saying, “How many losses can you take?” Woolco’s problems
necessitated a write-off of $325 million, but management believed it was bet-
ter to go ahead and “bite the bullet” rather than let the losing stores bleed
the company to death.

6. As a result of some imprudent loans to oil companies and to developing
nations, Continental Illinois, one of the largest U.S. bank holding companies
at the time, was threatened with bankruptcy. Continental then sold off sev-
eral profitable divisions, such as its leasing and credit card operations, to
raise funds to cover bad-loan losses. In effect, Continental sold assets in
order to stay alive. Ultimately, Continental was bailed out by the Federal
Deposit Insurance Corporation and the Federal Reserve, which arranged a
$7.5 billion rescue package and provided a blanket guarantee for all of Conti-
nental’s $40 billion of deposits, which kept deposits in excess of $100,000
from fleeing the bank because of their uninsured status.

As the preceding examples illustrate, the reasons for divestitures vary
widely. Sometimes the market feels more comfortable when firms “stick to their
knitting”; the Pepsi and United Airlines divestitures are examples. Other com-
panies need cash either to finance expansion in their primary business lines or
to reduce a large debt burden, and divestitures can be used to raise this cash;

19 Another forced divestiture involved Du Pont and General Motors. In 1921, GM was in serious
financial trouble, and Du Pont supplied capital in exchange for 23 percent of the stock. In the 1950s,
the Justice Department won an antitrust suit that required Du Pont to spin off (to Du Pont’s stock-
holders) its GM stock.

710 Part 7 Special Topics in Financial Management

Continental Bank illustrates this point. The divestitures also show that running a
business is a dynamic process—conditions change, corporate strategies change in
response, and as a result firms alter their asset portfolios by acquisitions and/or
divestitures. Some divestitures, such as Woolworth’s liquidation of its Woolco
stores, are to unload losing assets that would otherwise drag the company down.
The AT&T example is one of the many instances in which a divestiture is the
result of an antitrust settlement. The GM spin-off illustrates a situation in which
parts of the business can operate more efficiently alone than together.

What are some reasons companies divest assets?

What are four major motives for divestitures?

Tying It All Together

This chapter included discussions of mergers, divestitures, and LBOs. The
majority of the discussion in this chapter was on mergers. We discussed the
rationale for mergers, different types of mergers, the level of merger activ-
ity, merger regulation, and merger analysis. We showed how to use two dif-
ferent approaches to value the target firm: discounted cash flow and mar-
ket multiple analyses. We also explained how the acquiring firm can
structure its takeover bid, the accounting treatment of mergers, and invest-
ment bankers’ roles in arranging and financing mergers. In addition, we dis-
cussed two cooperative arrangements that fall short of mergers: corporate,
or strategic, alliances and joint ventures.

SELF-TEST QUESTIONS AND PROBLEMS
(Solutions Appear in Appendix A)

ST-1 Key terms Define each of the following terms:
ST-2
a. Synergy; merger
b. Horizontal merger; vertical merger; congeneric merger; conglomerate merger
c. Friendly merger; hostile merger; defensive merger; tender offer; target company;

breakup value; acquiring company
d. Operating merger; financial merger; equity residual method; market multiple analysis
e. White knight; white squire; poison pill; golden parachute; proxy fight
f. Joint venture; corporate alliance
g. Divestiture; spin-off; leveraged buyout (LBO); carve-out; liquidation
h. Arbitrage
i. Goodwill; purchase method

Merger value Pizza Place, a national pizza chain, is considering purchasing a smaller
chain, Western Mountain Pizza. Pizza Place’s analysts project that the merger will result
in incremental net cash flows of $1.5 million in Year 1, $2 million in Year 2, $3 million in
Year 3, and $5 million in Year 4. In addition, Western’s Year 4 cash flows are expected to
grow at a constant rate of 5 percent after Year 4. Assume all cash flows occur at the end
of the year. The acquisition would be made immediately, if it were undertaken. Western’s
post-merger beta is estimated to be 1.5, and its post-merger tax rate would be 40 percent.

Chapter 21 Mergers and Acquisitions 711

The risk-free rate is 6 percent, and the market risk premium is 4 percent. What is the
value of Western Mountain Pizza to Pizza Place?

QUESTIONS

21-1 Four economic classifications of mergers are (1) horizontal, (2) vertical, (3) conglomerate,
21-2 and (4) congeneric. Explain the significance of these terms in merger analysis with regard to
21-3 (a) the likelihood of governmental intervention and (b) possibilities for operating synergy.
21-4
Firm A wants to acquire Firm B. Firm B’s management agrees that the merger is a good
21-5 idea. Might a tender offer be used?

Distinguish between operating mergers and financial mergers.

In the spring of 1984, Disney Productions’ stock was selling for about $3.125 per share
(all prices have been adjusted for 4-for-1 splits in 1986 and 1992). Then Saul Steinberg, a
New York financier, began acquiring it, and after he had 12 percent, he announced a ten-
der offer for another 37 percent of the stock—which would bring his holdings up to
49 percent—at a price of $4.22 per share. Disney’s management then announced plans to
buy Gibson Greeting Cards and Arvida Corporation, paying for them with stock. It also
lined up bank credit and (according to Steinberg) was prepared to borrow up to
$2 billion and use the funds to repurchase shares at a higher price than Steinberg was
offering. All of these efforts were designed to keep Steinberg from taking control. In
June, Disney’s management agreed to pay Steinberg $4.84 per share, which gave him a
gain of about $60 million on a 2-month investment of about $26.5 million.

When Disney’s buyback of Steinberg’s shares was announced, the stock price fell
almost instantly from $4.25 to $2.875. Many Disney stockholders were irate, and they
sued to block the buyout. Also, the Disney affair added fuel to the fire in a congressional
committee that was holding hearings on proposed legislation that would (1) prohibit
someone from acquiring more than 10 percent of a firm’s stock without making a tender
offer for all the remaining shares, (2) prohibit poison pill tactics such as those Disney’s
management had used to fight off Steinberg, (3) prohibit buybacks such as the deal even-
tually offered to Steinberg (greenmail) unless there was an approving vote by stockhold-
ers, and (4) prohibit (or substantially curtail) the use of golden parachutes (the one thing
Disney’s management did not try).

Set forth the arguments for and against this type of legislation. What provisions, if
any, should it contain? Also, look up Disney’s current stock price to see how its stock-
holders have actually fared. Note that Disney’s stock was split 3-for-1 in July 1998.

Two large, publicly owned firms are contemplating a merger. No operating synergy is
expected. However, since returns on the 2 firms are not perfectly positively correlated,
the standard deviation of earnings would be reduced for the combined corporation. One
group of consultants argues that this risk reduction is sufficient grounds for the merger.
Another group thinks this type of risk reduction is irrelevant because stockholders can
themselves hold the stock of both companies and thus gain the risk-reduction benefits
without all the hassles and expenses of the merger. Whose position is correct? Explain.

PROBLEMS

Easy 21-1 The following information is required to work Problems 21-1, 21-2, and 21-3.
Problems 1–3 21-2
Harrison Corporation is interested in acquiring Van Buren Corporation. Assume that the
risk-free rate of interest is 5 percent and the market risk premium is 6 percent.

Valuation Van Buren currently expects to pay a year-end dividend of $2.00 a share (D1 =
$2.00). Van Buren’s dividend is expected to grow at a constant rate of 5 percent a year,
and its beta is 0.9. What is the current price of Van Buren’s stock?

Merger valuation Harrison estimates that if it acquires Van Buren, the year-end dividend
will remain at $2.00 a share, but synergies will enable the dividend to grow at a constant
rate of 7 percent a year (instead of the current 5 percent). Harrison also plans to increase the
debt ratio of what would be its Van Buren subsidiary—the effect of this would be to raise
Van Buren’s beta to 1.1. What is the per-share value of Van Buren to Harrison Corporation?

712 Part 7 Special Topics in Financial Management

Intermediate 21-3 Merger bid On the basis of your answers to Problems 21-1 and 21-2, if Harrison were to
Problems 4–5 21-4 acquire Van Buren, what would be the range of possible prices that it could bid for each
share of Van Buren common stock?
Challenging
Problem Merger analysis Apilado Appliance Corporation is considering a merger with the Vac-
caro Vacuum Company. Vaccaro is a publicly traded company, and its current beta is
1.30. Vaccaro has been barely profitable, so it has paid an average of only 20 percent in
taxes during the last several years. In addition, it uses little debt, having a debt ratio of
just 25 percent.

If the acquisition were made, Apilado would operate Vaccaro as a separate, wholly
owned subsidiary. Apilado would pay taxes on a consolidated basis, and the tax rate
would therefore increase to 35 percent. Apilado also would increase the debt capitaliza-
tion in the Vaccaro subsidiary to 40 percent of assets, which would increase its beta to
1.47. Apilado’s acquisition department estimates that Vaccaro, if acquired, would pro-
duce the following net cash flows to Apilado’s shareholders (in millions of dollars):

Year Net Cash Flows

1 $1.30
2 1.50
3 1.75
4 2.00
5 and beyond
Constant growth at 6%

21-5 These cash flows include all acquisition effects. Apilado’s cost of equity is 14 percent, its
21-6 beta is 1.0, and its cost of debt is 10 percent. The risk-free rate is 8 percent.

a. What discount rate should be used to discount the estimated cash flows? (Hint: Use
Apilado’s rs to determine the market risk premium.)

b. What is the dollar value of Vaccaro to Apilado?
c. Vaccaro has 1.2 million common shares outstanding. What is the maximum price per

share that Apilado should offer for Vaccaro? If the tender offer is accepted at this
price, what will happen to Apilado’s stock price?

Capital budgeting analysis The Stanley Stationery Shoppe wishes to acquire The Carl-
son Card Gallery for $400,000. Stanley expects the merger to provide incremental earn-
ings of about $64,000 a year for 10 years. Ken Stanley has calculated the marginal cost of
capital for this investment to be 10 percent. Conduct a capital budgeting analysis for
Stanley to determine whether or not he should purchase The Carlson Card Gallery.

Merger analysis TransWorld Communications Inc., a large telecommunications com-
pany, is evaluating the possible acquisition of Georgia Cable Company (GCC), a regional
cable company. TransWorld’s analysts project the following post-merger data for GCC (in
thousands of dollars):

2006 2007 2008 2009

Net sales $450 $518 $555 $600
Selling and administrative
45 53 60 68
expense 18 21 24 27
Interest
Tax rate after merger 35%
Cost of goods sold as a
65%
percent of sales 1.50
Beta after merger 8%
Risk-free rate 4%
Market risk premium
Terminal growth rate of cash flow 7%

available to TransWorld

If the acquisition is made, it will occur on January 1, 2006. All cash flows shown in the
income statements are assumed to occur at the end of the year. GCC currently has a cap-
ital structure of 40 percent debt, but TransWorld would increase that to 50 percent if the
acquisition were made. GCC, if independent, would pay taxes at 20 percent, but its
income would be taxed at 35 percent if it were consolidated. GCC’s current market-
determined beta is 1.40, and its investment bankers think that its beta would rise to 1.50

Chapter 21 Mergers and Acquisitions 713

if the debt ratio were increased to 50 percent. The cost of goods sold is expected to be
65 percent of sales, but it could vary somewhat. Depreciation-generated funds would be
used to replace worn-out equipment, so they would not be available to TransWorld’s
shareholders. The risk-free rate is 8 percent, and the market risk premium is 4 percent.

a. What is the appropriate discount rate for valuing the acquisition?
b. What is the terminal value? What is the value of GCC to TransWorld?

COMPREHENSIVE/SPREADSHEET
PROBLEM

21-7 Merger analysis Use the spreadsheet model to rework Problem 21-6, and then answer
the following question:

c. Suppose GCC has 120,000 shares outstanding. What is the maximum per-share price
TransWorld should offer for GCC?

Integrated Case

Smitty’s Home Repair Company

21-8 Merger analysis Smitty’s Home Repair Company, a regional hardware chain that specializes in “do-it-yourself” mate-
rials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the
excess funds is an acquisition. Linda Wade, Smitty’s treasurer and your boss, has been asked to place a value on a
potential target, Hill’s Hardware, a small chain that operates in an adjacent state, and she has enlisted your help.

The table below indicates Wade’s estimates of Hill’s earnings potential if it came under Smitty’s management
(in millions of dollars). The interest expense listed here includes the interest (1) on Hill’s existing debt, (2) on new
debt that Smitty’s would issue to help finance the acquisition, and (3) on new debt expected to be issued over
time to help finance expansion within the new “H division,” the code name given to the target firm. The reten-
tions represent earnings that will be reinvested within the H division to help finance its growth.

Hill’s Hardware currently uses 40 percent debt financing, and it pays federal-plus-state taxes at a 30 percent
rate. Security analysts estimate Hill’s beta to be 1.2. If the acquisition were to take place, Smitty’s would increase
Hill’s debt ratio to 50 percent, which would increase its beta to 1.3. Further, because Smitty’s is highly profitable,
taxes on the consolidated firm would be 40 percent. Wade realizes that Hill’s Hardware also generates deprecia-
tion cash flows, but she believes that these funds would have to be reinvested within the division to replace
worn-out equipment.

Wade estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. She also esti-
mates that net cash flows after 2009 will grow at a constant rate of 6 percent. Smitty’s management is new to the
merger game, so Wade has been asked to answer some basic questions about mergers as well as to perform the
merger analysis. To structure the task, Wade has developed the following questions, which you must answer and
then defend to Smitty’s board.

a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations,
(2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, and (5) synergy. In general,
which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.

b. Briefly describe the differences between a hostile merger and a friendly merger.
c. Use the data developed in the table to construct the H division’s cash flow statements for 2006 through 2009.

Why is interest expense deducted in merger cash flow statements, whereas it is not normally deducted in a
capital budgeting cash flow analysis? Why are earnings retentions deducted in the cash flow statement?

2006 2007 2008 2009

Net sales $60.0 $90.0 $112.5 $127.5
Cost of goods sold (60%) 36.0 54.0 67.5 76.5
Selling/administrative expense 4.5 6.0 7.5 9.0
Interest expense 3.0 4.5 4.5 6.0
Necessary retained earnings 0.0 7.5 6.0 4.5

714 Part 7 Special Topics in Financial Management

d. Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c? What is
your actual estimate of this discount rate?

e. What is the estimated terminal value of the acquisition; that is, what is the estimated value of the H divi-
sion’s cash flows beyond 2009? What is Hill’s value to Smitty’s? Suppose another firm were evaluating Hill’s
as an acquisition candidate. Would they obtain the same value? Explain.

f. Assume that Hill’s has 10 million shares outstanding. These shares are traded relatively infrequently, but the
last trade, made several weeks ago, was at a price of $9 per share. Should Smitty’s make an offer for Hill’s? If
so, how much should it offer per share?

g. What merger-related activities are undertaken by investment bankers?

Please go to the ThomsonNOW Web site to access the
Cyberproblems.

APPENDIX A

Solutions to Self-Test Questions and Problems

Note: Except for Chapter 1, we do not show an answer for ST-1 problems because they are verbal
rather than quantitative in nature.

CHAPTER 1

ST-1 Refer to the marginal glossary definitions or relevant chapter sections to check your
responses.

CHAPTER 2

ST-2 a. 1/1/06 8% 1/1/07 1/1/08 1/1/09
Ϫ1‚000 FV=?

$1,000 is being compounded for 3 years, so your balance on January 1, 2009, is
$1,259.71:

FVN ϭ PV 11 ϩ I 2 N ϭ $1,000 11 ϩ 0.08 2 3 ϭ $1,259.71

Alternatively, using a financial calculator, input N ϭ 3, I/YR ϭ 8, PV ϭ Ϫ1000,
PMT ϭ 0, and FV ϭ ? Solve for FV ϭ $1,259.71.

b. 1/1/06 2% 1/1/07 1/1/08 1/1/09
Ϫ1‚000 FV=?

FVN ϭ PV a 1 ϩ INOM NM ϭ FV12 ϭ $1,000 11.02 2 12 ϭ $1,268.24
M
b

Alternatively, using a financial calculator, input N ϭ 12, I/YR ϭ 2, PV ϭ Ϫ1000,

PMT ϭ 0, and FV ϭ ? Solve for FV ϭ $1,268.24.

c. 1/1/06 8% 1/1/07 1/1/08 1/1/09

Ϫ333.333 Ϫ333.333 Ϫ333.333
FV=?

Using a financial calculator, input N ϭ 3, I/YR ϭ 8, PV ϭ 0, PMT ϭ Ϫ333.333, and
FV ϭ ? Solve for FV ϭ $1,082.13.

d. 1/1/06 8% 1/1/07 1/1/08 1/1/09
FV=?
Ϫ333.333 Ϫ333.333 Ϫ333.333

Using a financial calculator in begin mode, input N ϭ 3, I/YR ϭ 8, PV ϭ 0,
PMT ϭ Ϫ333.333, and FV ϭ ? Solve for FV ϭ $1,168.70.

A-1

A-2 Appendix A Solutions to Self-Test Questions and Problems

e. 1/1/06 8% 1/1/07 1/1/08 1/1/09
?
??
FV=1,259.71

ST-3 Using a financial calculator, input N ϭ 3, I/YR ϭ 8, PV ϭ 0, FV ϭ 1259.71, and
PMT ϭ ? Solve for PMT ϭ Ϫ$388.03. Therefore, you would have to make 3 payments
of $388.03 each beginning on January 1, 2007.

a. Set up a time line like the one in the preceding problem:

1/1/06 8% 1/1/07 1/1/08 1/1/09 1/1/10
PV=? FV=1,000

Note that your deposit will grow for 4 years at 8 percent. The deposit on January 1,
2006, is the PV, and the FV is $1,000. Using a financial calculator, input N ϭ 4,
I/YR ϭ 8, PMT ϭ 0, FV ϭ 1000, and PV ϭ ? Solve for PV ϭ Ϫ$735.03.

PV ϭ FVN ϭ $1,000 ϭ $735.03
11 ϩ I2N 11.08 2 4

b. 1/1/06 8% 1/1/07 1/1/08 1/1/09 1/1/10
? ? ?
?
FV=1,000

Here we are dealing with a 4-year annuity whose first payment occurs 1 year from
today, on 1/1/07, and whose future value must equal $1,000. You should modify the
time line to help visualize the situation. Using a financial calculator, input N ϭ 4,
I/YR ϭ 8, PV ϭ 0, FV ϭ 1000, and PMT ϭ ? Solve for PMT ϭ Ϫ$221.92.

c. This problem can be approached in several ways. Perhaps the simplest is to ask this
question: “If I received $750 on 1/1/07 and deposited it to earn 8 percent, would I
have the required $1,000 on 1/1/10?” The answer is no.

1/1/06 8% 1/1/07 1/1/08 1/1/09 1/1/10
Ϫ750 FV=?

FV3 ϭ $750 11.08 2 11.08 2 11.08 2 ϭ $944.78

This indicates that you should let your father make the payments of $221.92 rather
than accept the lump sum of $750.

You could also compare the $750 with the PV of the payments as shown here:

1/1/06 8% 1/1/07 1/1/08 1/1/09 1/1/10
Ϫ221.92 Ϫ221.92 Ϫ221.92
Ϫ221.92
PV=?

Using a financial calculator, input N ϭ 4, I/YR ϭ 8, PMT ϭ Ϫ221.92, FV ϭ 0, and
PV ϭ ? Solve for PV ϭ $735.03.

This is less than the $750 lump sum offer, so your initial reaction might be to accept
the lump sum of $750. However, this would be a mistake. The problem is that when
you found the $735.03 PV of the annuity, you were finding the value of the annuity
today, on January 1, 2006. You were comparing $735.03 today with the lump sum of
$750 one year from now. This is, of course, invalid. What you should have done was
take the $735.03, recognize that this is the PV of an annuity as of January 1, 2006,