Mergers and Acquisitions

There is no more dramatic or controversial activity in corporate fi-

nance than the acquisition of one firm by another or the merger of two

firms. The acquisition of one firm by another is, of course, an investment

made under uncertainty. The basic principle of valuation applies: A firm

should be acquired if it generates a positive net present value (NPV) to

the shareholders of the acquiring firm.

There are three basic legal procedures that one firm can use to ac-

quire another firm: (1) merger or consolidation, (2) acquisition of stock,

and (3) acquisition of assets.

A merger refers to the absorption of one firm by another. The acquir-

ing firm retains its name and its identity, and it acquires all of the assets

and liabilities of the acquired firm. After a merger, the acquired firm

ceases to exist as a separate business entity. A consolidation is the same as

a merger except that an entirely new firm is created. In a consolidation,

both the acquiring firm and the acquired firm terminate their previous

legal existence and become part of the new firm. In a consolidation, the

distinction between the acquiring and the acquired firm is not impor-

tant. However, the rules for mergers and consolidations are basically the

same. Acquisitions by merger and consolidation result in combinations

of the assets and liabilities of acquired and acquiring firms.

There are some advantages and some disadvantages to using a merger

to acquire a firm:

1. A merger is legally straightforward and does not cost as much as

other forms of acquisition. It avoids the necessity of transferring title of

each individual asset of the acquired firm to the acquiring firm.

2. A merger must be approved by a vote of the stockholders of each

firm. Typically, two thirds of the shares are required for approval. In

addition, shareholders of the acquired firm have appraisal rights. This

means that they can demand that their shares be purchased at a fair value

by the acquiring firm. Often the acquiring firm and the dissenting share-

holders of the acquired firm cannot agree on a fair value, which results

in expensive legal proceedings.

The second way to acquire another firm is to purchase the firm’s voting

stock in exchange for cash, shares of stock, or other securities. This may

start as a private offer from the management of one firm to another. At

some point the offer is taken directly to the selling firm’s stockholders.

This can be accomplished by use of a tender offer. A tender offer is a public

offer to buy shares of a target firm. It is made by one firm directly to the

shareholders of another firm. The offer is communicated to the target

firm’s shareholders by public announcements such as newspaper adver-

tisement. Sometimes a general mailing is used in a tender offer. How-

ever, a general mailing is very difficult because it requires the names and

addresses of the stockholder record, which are not usually available.

One firm can acquire another firm by buying all of its assets. A formal

vote of the shareholders of the selling firm is required. This approach to

acquisition will avoid the potential problem of having minority share-

holders, which can occur in an acquisition of stock. Acquisition of assets

involves transferring title to assets. The legal process of transferring as-

sets can be costly.

Financial analysts have typically classified acquisitions into three

types:

1. Horizontal Acquisition. This is an acquisition of a firm in the same

industry as the acquiring firm. The firms compete with each other in

their product market.

2. Vertical Acquisition. A vertical acquisition involves firms at different

steps of the production process. The acquisition by an airline company

of a travel agency would be a vertical acquisition.

3. Conglomerate Acquisition. The acquiring firm and the acquired

firm are not related to each other. The acquisition of a food-products firm

by a computer firm would be considered a conglomerate acquisition.

Unit 7