To reiterate a point made several times already, merger for its own sake is to be avoided. It has its best chance of success when entered into for reasons of strategic necessity. Even then internal growth may produce the same strategic results without the inherent problems merger can involve.
The term merger strategy refers, in effect, to the major benefits each party to a merger is seeking. As is true of other strategy areas, merger strategy is defined here as a set of guidelines that define essentially how various functional managers should proceed to carry out their respective parts of a corporate-level strategy (acquiring a business unit) and what results they expect to achieve by doing so. Some firms create merger committees to handle the details of a merger, some delegate responsibility for overseeing the process to a department (often finance) or individual, and others leave the details to the CEO or outside professionals.
Since merger strategy is intended to guide the search for merger candidates, ultimate "selection" of a single firm would be subject to negotiations. Thus merger strategy consists of the following set of variables, which define an "ideal" merger partner relative to the strategic needs of the firm:
TYPES OF MERGERS
There are four legal types of mergers:2 statutory merger,
consolidation, acquisition of assets, and acquisition of stock. Although
these terms have distinct legal meanings, there is some disagreement on
precise definitions, as some of the definitions have narrow legal meanings
whereas others have broad meanings.
Statutory Merger
Statutory merger is the absorption of one firm's assets, debts, and
common stock by another firm. From an accounting viewpoint, this is called
a purchase. Normally, the target is a firm much smaller that the acquiring
firm.3 The buyer assumes all legal responsibility for the absorbed
firm, which ceases to exist as a legal entity.4 The buyer also
assumes the seller's debts and pays off the seller's stockholders with
whatever form of exchange was agreed upon, and continues to operate with
title to the seller's assets. A good example of a statutory merger is Tenneco's
acquisition of the Kern County Land Company. After this transaction Tenneco
had to pay Kern's debts, owned its assets, and continued operating under
common management and ownership. Tenneco's management was augmented by
Kern's managers, whom Tenneco agreed to retain. Also, Tenneco's group of
preferred stockholders was increased by those of Kern's stockholders, who
accepted Tenneco shares in return for their Kern's shares (Tenneco gave
one share of convertible preferred stock worth about $105 for each share
of Kern's stock).5
As an example, suppose firm ABC acquires firm XYZ in a merger and that the terms of exchange are one ABC share for three XYZ shares. That is, XYZ's shareholders would receive one ABC share in return for three of their XYZ shares. ABC stockholders are largely unaffected in a legal way but XYZ's stocks no longer exist after the merger.6
Consolidation
When two firms are combined such that a new, third legal entity is
formed, it is called a consolidation. Here a new corporation is usually
formed that receives the assets, liabilities, and stock of both consolidating
firms, whose owners are reimbursed in cash, or in the new firm's stocks
or bonds. The normal distinctions between buyer and seller or acquiring
and acquired firm are not important in a consolidation.7 Although
their "bricks and mortar" survive, the combining companies cease to exist
as legal entities. Consolidation usually requires approval by the stockholders
of each firm, as does a statutory merger.
An example of consolidation is the combination of Olin Industries and the Mathieson Chemical Corporation into the Olin Mathieson Chemical Corporation. Generally, continuing with the company ABC and XYZ example above, were these two firms involved in a consolidation instead of a statutory merger, each firm's shareholders would exchange their shares for stocks in a new company that we might call DEF company.
Merger and consolidation are less expensive to consummate than other forms of combination and legally, they are straightforward.8 Also, it is unnecessary in either case to transfer assets one-at-a-time. Each stockholder group must approve the move by a two-thirds (of the shares) vote and the target's shareholders have appraisal rights--they can demand fair market value for their shares. Disagreements between the acquiring firm and the minority (dissenting) shareholders of the target firm over price for mergers and consolidations tend to generate expensive legal battles.9
For our purposes, statutory mergers and consolidations are different only in a political way. This means only that sometimes one or the other makes more sense to the parties involved in the transaction. Beyond this, however, the rules governing both are largely the same. Both result in the combination of assets and liabilities of the two parties.
Regardless of the type of combination, when one firm buys another firm, the transaction could be taxable or tax-free. It would be taxable when the target's stockholders are considered to have sold their shares and realized a capital gain or loss. Here, the appraised value of the seller's assets could be re-valued and the buyer could then claim depreciation expense on the new asset value. The seller would pay taxes on the difference between the original asset purchase price and the merger price. The deal would be tax-free when stocks of equal value were exchanged so that no capital gain or loss occurred; assets would not have to be re-valued. According to IRS Code 368(a)(1), the transaction is tax-free when the primary consideration paid to obtain the voting stock or assets of the target firm are voting stock of the acquiring firm.10 In the tax-free case, the buyer would be allowed no additional depreciation and the seller would not have to pay tax until shares received in the deal were sold.11
Acquisition of Stock
A holding company is a legal form of business organization in which
a firm owns (holds) common stock of other firms. They are formed when one
firm buys the target firm's voting stock in return for cash, shares of
stock, or other securities. Although the process may start as an offer
by one firm's management to another, at some time the offer has to be taken
directly to the stockholders of the selling firm.12 This is
accomplished with a tender offer, a public offer to buy stocks of the target
company, to the shareholders of the target by the management of the buyer.
The parent firm can gain control of a subsidiary by owning enough of its stock. Control is guaranteed if over 50 percent is owned. However, effective control can be maintained with much less than 50 percent. It is generally considered established with 25 percent of the common stock, but it can be as low as 10 percent if ownership is widely distributed. Brigham notes that "the attitude of management is more important than the number of shares owned ... 'if they think they can control the company, then you do.' In addition, control on a very slim margin can be held through friendships with large stockholders outside the holding company group."13
If shareholders in the target firm don't like the offer, they don't have to accept it, and no shareholder meeting has to be held. The acquiring firm (called the bidder) can deal directly with stockholders of the target, thus bypassing the managers and directors, through the use of a tender offer. Obviously, such a move can lead to unfriendly terms between management of the target and the bidder. The target's management would likely be replaced by the bidder's people should the deal be consummated and they typically openly resist the acquisition of stock. When there is a minority of stockholders who refuse to sell or exchange their shares, the target cannot be completely absorbed by the bidder. Were this not the case, then the deal would be a merger or consolidation. In fact, acquisitions of stock often end in a formal merger after the initial negotiations have run their course.14
An example of a holding company is AT&T, which owned controlling interest in a large number of local and regional operating companies as well as telephone manufacturing and research, data processing, and long distance communication facilities. The January 1982 decision of the U.S. Justice Department requiring AT&T to divest itself of $84 billion worth of operating company subsidiaries (a decision favored by AT&T) significantly changed the nature of its business. Other examples of acquisitions of stock are Dun & Bradstreet of A.C. Nielsen, General Motors of Electronic Data Systems (Ross Perot's business), Du Pont of Conoco, Chevron of Gulf, and Bristol-Myers of Squibb.15
Asset Acquisition
The final type of merger is by asset acquisition. In some cases a company
may wish to purchase the assets of another company rather than to gain
ownership or control of its stock. Although this approach to acquisition
of a firm will avoid the creation of minority stockholders and attendant
problems of acquisition of stock, the legal process of asset transfer can
be expensive. Also, a formal vote by the target's shareholders is required.
However, where the buyer purchased all of the assets of the seller, the
purpose may have been to liquidate the selling company. Proceeds of the
sale would be used, in this case, to pay off creditors. Whatever cash remained
would be distributed among stockholders and the firm thus would be dissolved.
An asset purchase can be transacted by any means of exchange, including cash and stock. Some firms purchase assets of other firms in exchange for assumption of certain or all of the seller's debts.
Takeovers
The foregoing types of merger are dubbed "friendly mergers" when the
terms are approved by the management groups of both parties. However, when
the parties are unable to reach agreement on terms, two things can happen.
Negotiations can be broken off and the proposed merger terminated, or the
acquiring firm can attempt a takeover.
When the target company's management objects to the acquiring company's merger proposal and proceeds to attempt a takeover, it is called a "hostile merger." The acquiring company's management can "go over the heads" of the hostile management of the target company by making an appeal directly to the target firm's stockholders. Such an appeal is called a tender offer because it involves asking the stockholders of the target company to offer, or "tender," their shares in exchange for a certain price. A tender offer, however, is not necessarily unfriendly. Management of the target firm may be receptive to the offer and recommend that the stockholders tender their shares.16
When the target firm's management decides to fight the takeover there are several tactics available. Very often the decision to fight is based on managers' attempts to protect their jobs. Certainly such a decision is outside of their responsibilities when their own stockholders favor the offer.17 However, trying to get a better offer or a better strategic fit is within their responsibilities. Stockholders should determine whose interests are being protected by management's opposition to a merger proposal.
Probably because of the rash of takeovers during the last decade, the palette of takeover defensive tactics has increased dramatically. Some of the possibilities are publicity campaigns, stock purchases, court actions, defensive mergers,18 the corporate charter, repurchase standstill agreements, going public and leveraged buyouts, golden parachutes, crown jewels, poison pills,19 defensive restructuring, poison puts, and antitakeover amendments.20 Although a detailed explanation of each tactic is beyond the purposes of the book, each will be defined next.
Publicity campaigns. Management can commence a media campaign to convince stockholders, customers, suppliers, and other interested groups of the inadvisability of the takeover. Often, this approach turns into a media-based war of words between the target firm's management and the acquirer's management.
Stock purchases. A stock purchase involves the target company making a tender offer to buy back its own stock, often at a premium relative to the acquirer's offer. A special case, the exclusionary self-tender, applies to the stock purchases that carry an exclusion of the offer to troublesome stockholders. These tender offers are usually for amounts above the prevailing market price. Thus, they have the effect of taking wealth away from the firm that is in the process of buying up the target's stock by transferring it to the non-excluded stockholders.
Court actions. Another defensive tactic that can be taken by an unwilling takeover target is to file a court action against the acquirer. The target can file anti-trust suits against the bidder and may even purchase certain assets that will cause anti-trust problems for the bidder.
The corporate charter. The target's articles of incorporation and bylaws establish the conditions that allow a takeover. Firms can amend their charters to make takeovers more difficult. One choice is the require an eighty percent vote to approve a merger, a so-called super-majority, instead of the usual two-thirds majority. Another is to stagger the election of board members. This makes it more difficult to elect new members quickly who are favorable to the takeover.
Repurchase agreements. A number of repurchase agreements have been attempted. In one, the targeted repurchase, the target buys back its own stock from a potential bidder, normally at a large premium. This form of greenmail essentially buys off the bidder. Standstill agreements are usually negotiated concurrently with repurchase deals. These agreements limit the bidder's holdings of the target firm and stop the takeover attempt. There is usually a simultaneous reduction in stock price.
Going private and LBOs. Going private is when a group composed of the target's management makes a tender offer for its public stock. The target's stock becomes delisted on its exchange and is no longer traded. This results in stockholders being forced to accept cash for their shares.
A leveraged buyout (LBO) can be used as a vehicle for financing going private. The offer is financed by cash derived by large amounts of debt and requires only small amounts of equity. What little equity is necessary usually comes willingly from existing management. Leveraged buyouts are interesting because they usually involve huge amounts of debt. But they usually occur in large, stable firms with little or moderate debt loads. So the LBO-related debt may just raise the firm's debt level to a normal amount. The second distinguishing feature of LBOs is that they turn former managers into owners and consequently increase their incentive to work hard for the profitability of the firm.
Golden parachutes. These are clauses in management peoples' employment contracts that necessitate giving them a large lump-sum (usually) payment when ownership changes. One view of golden parachutes is that they provide an incentive to management to fight harder for the benefit of stockholders. Another is that they enrich management at the expense of stockholders.
Crown jewels. Crown jewels are assets of the target that are of most interest to the bidder. They can simply be sold to remove the bidder's incentive to proceed with the takeover attempt. This is related to the scorched earth policy which involves incurring large amounts of debt to make the firm unattractive or selling off segments appealing to the bidder.
Poison pills. Poison pills are warrants or convertible preferred stock issued to current stockholders giving them the right to buy shares in the target firm at a low price in the event of another firm acquiring control. The presence of a poison pill clause dilutes the value of the stock to the point where the bidder would lose money on its holdings.
Poison puts. Clauses allowing poison puts give bondholders of the target firm the option to sell (put) their bonds to the firm, or its subsequent owners, usually at a premium.
There are other types of takeover defenses but most are special cases of the types already mentioned above. For cases requiring formulation of tactics with which to combat takeover attempts, students are advised to refer to the references cited above for additional detail on defense tactics.
STRATEGIC REASONS FOR MERGER
The type of merger that is most beneficial to both acquiring and target
firms is largely a strategic matter. Of course, the ultimate form a combination
actually takes depends upon a complex process of balancing a set of trade-offs
through negotiations between parties. The following results of mergers
constitute the list of possible benefits that could accrue to one party
or the other.(* Taken from lists presented by William A. Newman and
James P. Logan, Strategy, Policy, and Strategic Management (Cincinnati,
Ohio: South-Western, 1981), p. 187, and Weston and Copeland, Managerial
Finance, pp.1084-93.) A proposed merger would be justified by the
strategic need for one or some combination of these factors.
Synergy
Synergy in a merger can result in the ability to spread fixed costs
over a larger number of units produced. The combined entity may be able
to do away with one of its duplicate accounting, personnel, or other staff
departments, consolidate a line department, or even share a facility. A
popular choice is to have both sales forces sell both product lines and
thereby increase the ratio of sales per salesperson. Thus the combined
entity may be more efficient than either of the separate firms, and that
is the definition of synergy. If synergy is established, future after-tax
earnings and dividends should be higher than for either party alone.
It is here that stockholders benefit from the synergy of a merger.
Tax Savings
Prior to the Tax Reform Act of 1986, some mergers took place to take advantage of the seller's tax-loss carry forward. A profitable firm that acquired another firm with accumulated losses could reduce its tax liability by applying the losses against taxable income.
This reason for merging was outside the realm of strategic benefits, except where there was an inherent possibility for synergy and when it could result in an increase in the market value of equity.
The 1986 tax change affected mergers and acquisitions by requiring that the combination must not be for tax avoidance purposes. That is, it must have a business or strategic justification for tax-loss carryovers to apply. There are also other limitations on treatment of tax-loss carryforwards too detailed for our purposes. Further, the new law repealed the preferential rate for corporate capital gains, a minimum tax was applied to corporate earnings, and greenmail payments were deemed non-deductible.21 All in all, TRA 86 created a tax environment less favorable to mergers and acquisitions.22
Acquisition of Resources
When market access, production capabilities, patent rights, physical
assets, or other strategically important resources cannot be obtained otherwise,
they may be forthcoming by merging with a firm that has them. However,
these resources would have to be critically important and not obtainable
through a simple purchase for such a merger to be justified.
Increased Debt Capacity
Merger with a firm that has little or no debt, especially by an exchange
of stock, can increase the combined entity's debt/equity ratio. Thus its
borrowing capacity would increase.
Advantages over Internal Growth23
Merger can provide several advantages over internal growth. In circumstances
in which any of these advantages are critically important strategically,
they may serve as sufficient reasons to seek a merger partner. First, merger
can be a faster way than internal expansion for a buyer or seller to enter
a new market or introduce a new product line. The company could merge with
a firm already serving the desired market or producing the needed product
line. Second, employment costs for activities such as training, relocating,
and hiring are sometimes less with merger than with internal expansion.
Third, when expansion involves a new building, merger with a firm that
already has a facility can substantially bypass costly regulatory delays
typical of construction projects. Zoning laws, environmental impact statements,
and licensing requirements can prolong a building project indefinitely.
Fourth, when interest rates are high and stock prices low (so that a new
security offering would be unfavorable), a stock merger is an attractive
alternative to raising new expansion capital. Rather than sell undervalued
shares, the firm may prefer to finance an expansion merger by swapping
its stock for other low-priced stock. Finally, cash-rich undervalued firms
can provide liquidity to a buyer in a stock merger. Very often takeover
bids are precipitated by the proposed buyer attempting to acquire a cash-heavy
seller by exchanging stock.
Short-Term Earnings
In addition to enhancing future earnings and dividend streams, the
ultimate aim of the aforementioned reasons, merger can also change earnings
per share (EPS) in the short term. Either an increase or a decrease in
EPS can result from merger. An increase occurs when the buyer has a higher
price/earnings ratio (P/E = Market price per share/EPS) than the seller
and if additional fractional share premiums (fractions of shares above
a one-for-one exchange offered by the buyer to the seller's stockholders)
are less than the ratio of the seller's EPS to the buyer's EPS.24
To illustrate, suppose that Firm Buyer acquires Firm Seller by offering Seller's stockholders a one-for-one exchange of 200,000 new Buyer stocks. In Exhibit 3.1-A after-merger earnings would be $4 million with 700,000 outstanding shares. Dividing these two figures results in EPS of $4.29, a 7.3 percent increase over Buyer's previous EPS.
Suppose further that Seller's stockholders balked at this, holding out for a 10 percent premium over the market value of Seller stock they held before the merger. With this premium Buyer would still realize an instantaneous increase in EPS of $0.17. The 10 percent premium would mean Buyer would have to exchange 1.1 Buyer shares for each one of Seller's 200,000 shares. Therefore, at Buyer's current market price of $10 per share, the whole package would be worth $2.2 million, $200,000 more than the present market value of Seller's outstanding stock. In fact, as long as the premium is less than the excess above 1.0 of the ratio of Seller's EPS to Buyer's EPS (25 percent in this example), then Buyer would realize an EPS increase.
When the seller's P/E ratio is higher than the buyer's and the market value of the buyer's offer is greater than or equal to the market value of the seller's shares, then the buyer's EPS will be reduced by the merger.
Risk Reduction
Bolten and Conn explain that merger can result in a reduction of business
risk, financial risk, and marketability risk.25
Business risk is the extent to which a firm's strategy does not fit its environment. In other words, business risk is a subjective assessment of the firm's chances at success. Merger can
Financial risk can also be reduced by merger. Uncertainty about ability to pay dividends or bond payments causes investors to demand a higher return. This is the case when the firm's debt/equity ratio is high.
A merger can reduce a high debt/equity ratio for the buyer if the buyer merges with a seller with a low debt/equity ratio.
Marketability risk is an assessment of the ease with which a firm's securities can be sold at market price. It is a function of the number of stockholders, size of the outstanding issue, and daily average trading volume. Marketability risk declines with increases in these factors.
Thus in a stock exchange merger, the marketability risk of the buyer's shares declines because the number of stockholders increases, the size of the outstanding issue increases, and the average number of shares purchased daily tends to rise. It follows that investors would seek out the stock of firms with declining marketability risk and the market price would rise.
These three risk categories can be very important strategic factors at one time or another to a given business. But each one can be reduced by internal changes as well as by merger. The key difference is in the rapidity with which it is necessary, in a particular case, to effect a reduction in business risk, financial risk, or marketability risk. When time is critical, merger may be necessary.
Disadvantages of Mergers
Strategic management students tend to jump at the opportunity to recommend
a merger for a firm because of all the potential rewards it could generate.
However, there are some notable disadvantages that should be accounted
for whenever a merger recommendation is tempting.26
Erroneous forecasts of costs and benefits expected to result from a merger can be disastrous if actual performance falls below them. Earnings may decline and the price of the company's stock may fall. Thus analysis of a proposed merger's financial and operating impact through detailed pro forma financial statements and cash budgets is essential.
Chaos can also result from an attempt to integrate the buyer and seller. Friction between the two management teams is inevitable and systems must be designed prior to the combination to prevent it from becoming an impediment to operations.
Minority stockholders of the seller may cause dissension out of dissatisfaction with the value they received from their stock. Stockholders of the buyer can generate hostilities also by questioning the wisdom of the merger.
Antitrust action is an attempt by one of the various state or federal agencies to block a merger. State agencies regulate intrastate commerce and have less impact on large firms than on small ones. Federal agencies' jurisdictions are defined by interstate commerce activities and apply to virtually all large firms (and actually to most, if not all, small businesses as well). Although many federal agencies have antitrust responsibilities, the major ones are the Antitrust Division of the Department of Justice and the Federal Trade Commission.27
To "block a merger," the government, under Section 7 of the Clayton Act, must prove that a "substantial lessening of competition might occur" because of it.28 Also, since there is no statute of limitations in antitrust law, a long-standing combination can be dissolved. An example of such a case is the January 1982 decision requiring AT&T to divest $84 billion worth of local operating subsidiaries.
Before a merger is proposed, firms should estimate the likelihood of approval. Because of costs in executive time, legal expenses, and staff support, a merger that would have been successful if uncontested can become unprofitable.29
Three general guidelines can be used to asses preliminarily whether a merger will be challenged. If any of the following conditions is met by a merger, the merger is illegal:30
| Cash or warrants | 4 percent | |
| Debt | 19 | |
| Common stock | 31 | |
| Convertible preferred stock | 100 percent |
Type B reorganizations are also stock-for-stock exchanges but where the target is either liquidated into the acquirer or operated as a separate legal entity. Type Cs are stock-for-assets deals in which at least 80 percent of the fair market value of the target's assets is acquired.33
Negotiations between buyer and seller determine the final value of the exchange package. (**One estimate is that of all merger negotiations actually begun, only about one third result in merger. See E.F. Brigham, Economical Management: Theory and Practice, 2nd ed. (Hinsdale, Ill.: Dryden, 1979), p. 687.) Obviously the buying firm tries to purchase at the lowest possible price and the selling firm tries to sell at the highest possible price. The larger the role of strategic benefits in the exchange, the more room there is for bargaining and the higher the probability that the combination actually will reach fruition.34
Rationale of Merger Proposal
To each party merger represents a collection of items that is exchanged
for another collection of items.35 In that sense the definition
of "items" is quite broad because it includes whatever strategic requirements
precipitated the merger, the financial assets included, and the relationship
between the values of the packages. It must be viewed as considerably more
than a financial transaction where, for example, a certain number of one
firm's stock is purchased for an amount of cash or for a number of another
firm's stocks. As a starting point, however, a proposed merger must represent
a rational financial transaction.
Buyer's Viewpoint in a Cash Merger
When the proposed method of payment is cash, the merger can be modeled
in a capital budgeting framework, preferably in discounted cash flow terms.
Strategic concerns enter the model as effects on revenues and cost savings
expected to result from the strategic advantages (or synergies) it might
bring forth. The discounted cash flow model requires(1) understanding and
clear delineation of the likely impact on cash flows (both inflows and
outflows) of the strategic reasons for merger, (2) a decision on the terms
of exchange of the merger, (3) estimates of cash inflows and outflows,
and (4) computation of the appropriate discount rate.
The cash flow analysis (more specifically, it would be in a cash budget format whereby the present value of the merger had been determined through a discounted cash flow computation) is the basis on which the strategist decides whether or not to pursue the combination. Thus the cash budget becomes a useful control device for monitoring subsequent integration of the two firms.
Buyer's Viewpoint for Noncash Merger36
Mergers financed through methods of exchange other than cash or equivalents
are evaluated essentially on the basis of the exchange ratio (ER) represented
by the merger. Exchange ratio is the number of shares given by the buyer
for each share of the seller's stock. It can be computed by dividing the
number of the seller's shares by the number of buyer's shares.
For example, if the buyer were giving 100,000 shares for 75,000 of the seller's shares, the exchange ratio would be 0.75.
The most important influences on ER are current earnings, projected future earnings, and market prices, as discussed in the following sections. Current Earnings. Current earnings are represented by the EPS of each merger party. If the acquiring firm has EPS of $3 and the seller's is $2, then, if the firms are equally risky and have the same historical growth rate in earnings, the ER based on relative earnings is $2/$3 = 0.67. Thus the buyer exchanges sixty-seven shares for every one hundred seller shares. Notice that the effect of this exchange should be to leave the seller's earnings unchanged after the merger. Before the merger the seller's earnings for each one hundred shares would have been $2.00 x 100 = $200.
After the merger the seller's earnings would be $3.00 x 67 = $200 per one hundred shares. The buyer's earnings per one hundred shares would also be left unchanged by the merger because it would be $3.00 x 100 = $300 both before and after. Consequently the ER computation is useful for determining the number of shares that would have to be exchanged to maintain the earnings levels of both stockholder groups after the merger. It is a convenient starting point for estimating stock exchange rates because it assumes that no synergies will exist and that the firms have equal growth rates.38
Project Postmerger Earnings. When strategic advantages are expected to result from the merger (as should be the case whenever merger is recommended) so that earnings would increase, or when the parties do not have identical growth rates, forecasted EPS rather than historic EPS is used to compute ER. To estimate expected future earnings, a set of pro forma financial statements (balance sheet, income statement, and cash flow statement) would be prepared to reflect projected operations of the combined entities. Reducing the information contained in them to a usable form for the merger transaction involves modifying the previous ER calculation to take into consideration the expected impacts on earnings of either (1) continuation of the two parties' different growth rates, (2) synergies or other strategic advantages, or (3) both of these.
First, with the expectation that each party in our earlier example is expected to continue growing at its recent historical earnings growth rate of 8 percent for the buyer and 6 percent for the seller, calculations of ER for future periods produce different results. For the present time period, ER is 0.67, the seller's EPS of $2 divided by the buyer's $3. However, for one year hence the exchange ratio changes to $2.00(1.06)/3.00(1.08) = 0.654. For two years into the future, growth would further decrease the exchange ratio to 2.25/3.50 = 0.643. The resultant exchange ratio, therefore, varies with the number of years used for the computation even though the validity of the growth assumption becomes more and more tenuous with the greater number of years used. Certainly relative current earnings yield a different exchange ratio value from expected earnings based on growth.
Mergers undertaken for a strategic advantage would also be expected to result in earnings increases. These increases presumably would occur at rates above the parties' historical growth rates.
Suppose that in the merger example used above, the seller firm had certain advantageous plant locations, which, when coupled with the buyer's production expertise, were expected to yield a 30 percent increase in earnings. Thus the buyer's postmerger EPS would rise to $3.90 from the present $3.00. Both the seller's and the buyer's stockholders will realize better earnings as a result of this change. Specifically the seller's earnings will be 67 x $3.90 = $261.30 per one hundred shares after the merger versus 100 x $2.00 = $200 before it; the buyer's earnings will rise from 100 x $3.00 = $300 before the merger to 100 x $3.90 = $390 after it.
For the exchange ratio computation in this situation, Brigham recommends the following formula:38
| ER | = | exchange ratio | |
| TE | = | consolidated earnings (buyer's old earnings + seller's old earnings + expected additional earnings from merger) in dollars |
| EPSB | = | buyer's old EPS | |
| NB | = | number of buyer's shares outstanding before merger | |
| NS | = | number of seller's shares outstanding before merger |
| NS | = | 75,000 | |
| NB | = | 100,000 | |
| TE | = | $300,000 + $150,000 + $100,000 |
Of course, the buyer prefers the lowest possible exchange ratio, the seller wants the highest, and the actual ER is determined by negotiations.
Market Price and Seller's Viewpoint. To the seller firm, the primary question is whether the value of the resource package it is giving up is greater than the value of the package it is receiving. The market value of the seller's package is actually its "sticking point" in merger negotiations--the value below which the seller will not go. Rational managers would not sell the firm for less than its market value.
Firms can be sold at a premium--a price above the market value of stock. To the extent that the merger would enhance the strategic position of the combined firms, the buyer should be willing to pay a premium.
SUMMARY
Merger policy reflects the strategist's interpretation of what kind
of firm would make the ideal merger partner. It is intended to guide the
search for merger candidates. Before merger policy is constructed, however,
it is determined that merger has specific advantages over other, less risky,
forms of growth.
Merger policy consists of five elements: a description of the type of firm sought, the legal form of the merger, delineation of the strategic advantages sought, optimal terms of exchange, and a demonstration of the merger's expected financial impact in a set of pro forma financial statements.
First, the type of firm sought is described in product/market terms. Whatever characteristics are necessary for a good fit are included.
Second, the choices for legal form of a merger are statutory merger, consolidation, holding company, and asset acquisition. Although the final form a merger takes is not decided until negotiations begin, each party normally prefers one over the others.
Merger policy should also include a description of the strategic benefits sought in the merger. These would actually be the primary reasons for seeking a merger in the first place.
Fourth, terms of exchange are specified. A merger can be financed with stock, warrants, cash, or debt, and the final value of the packages exchanged is decided in negotiations. Cash mergers can be structured as a cash budgeting problem in a discounted cash flow framework. Those financed by means other than cash can be evaluated on the basis of an exchange ratio of numbers of shares exchanged by the buyer and seller. Several exchange ratio formulas were presented.
Finally, the expected financial impact of the merger is shown in the pro formas constructed to represent the overall strategy.