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FINANCE IN A CANADIAN
SETTING
Sixth Canadian Edition
Lusztig, Cleary, Schwab
CHAPTER
TWENTY-SIX
Mergers and Acquisitions
Learning Objectives
1. Identify the four types of external expansion
that a company may pursue.
2. Define synergy, and explain what effect it can
have on a merged company.
3. Describe some of the consequences for the
acquiring company when it is paying more
than the current market price for the shares
of the firm it is taking over.
Learning Objections
4. Identify the accounting concerns in an
acquisition, and discuss some of their
implications.
5. Discuss the major concerns involving
corporate concentration, declining
competition, increased debt loads, insider
trading, and other such topics.
Introduction
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Firms grow by generating new internal investments or
by acquiring businesses through external expansion
The framework for analyzing business combinations is
similar to capital budgeting
Business combinations can take the form of:
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Holding companies – a firm’s assets are shares of other
companies (BCE, CP, ONEX)
Mergers – two firms come together, with one losing its
corporate identity and being absorbed by the other
Amalgamations – also called consolidations, they are
common between equals
Motives for
Business Combinations
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The main motive for business combination
should be to enhance shareholder wealth
The factors that create shareholder wealth vary
and are reflected through several directions
external growth can take, which include:


Horizontal expansion – when a firm acquires
competitors that produce or distribute similar
products
Vertical integration – occurs when successive
stages of operation are integrated
Motives for
Business Combinations
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Circular expansion – brings different products
together that can be handled by similar technologies
or distributed channels
Conglomerate expansion – involves companies with
products or businesses that bear no relation to one
another
Synergy
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exists when the value of the combined company
exceeds the sum of the value of the two firms being
merged
can arise from economies of scale
the greatest synergies involve intangible assets
Motives for
Business Combinations

Improved management
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Market for corporate control – when acquisitions
are used as tools for ousting underperforming
managers
 many hostile takeovers are of this kind
Synergy-motivated takeovers or mergers are
usually friendly since the target firm’s managers
have less reason to fear losing their position
Bargain Price

when shareholders place too low a value on a
company’s shares a takeover may be profitable
Motives for
Business Combinations

Market power

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Improved financing
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Mergers lead to companies exercising market power,
thereby controlling prices charged to consumers
A merger with an established firm opens project
financing opportunities
Tax considerations
Search for liquidity and management skills

Owners of private firms with no successor plan may
be forced to sell out to obtain liquidity for retirement
Motives for
Business Combinations
Discounted
Cash Flow Analysis

The value an acquisition contributes to
the acquiring firm is given by the NPV
NPV = present value of incremental net future
cash flows that accrue because of the
acquisition
- the acquisition price

The discount rate to compute the NPV
must reflect the risk inherent in that
firm’s cash flows
Discounted
Cash Flow Analysis

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Because businesses have an indefinite economic
life, the selection of a proper time horizon is
critical
Alternative approaches to time horizon include:
1. Choice of an arbitrary cut-off date
2. Estimation of cash flows for a number of years, with
some assumptions regarding cash flows after that
date
3. Projections of cash flows to a specified cut-off,
followed by an assumed liquidation of the investment
at that time with estimated fair market value
Discounted
Cash Flow Analysis
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Firms that are liquid with unused debt
capacity are attractive takeover targets
because the acquisition can be financed by
the target company’s own financing
abilities after the takeover
Leveraged buyouts – when the acquiring
firm puts up a minimal amount of equity,
using the expected cash flows and assets
of the target company to obtain debt
financing
Accounting for
Business Combinations
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In Canada, surviving companies will
account for an acquisition through the
purchase method
Purchase method – when the assets of the
firm being acquired are revalued to reflect
the purchase price and are integrated into
the acquiring firm’s balance sheet at the
revised value
Effects of Mergers on
Earnings Per Share
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Most mergers have an immediate and
major impact on reported earnings, which
provides a strong misguided motive for
some mergers
Phantasmic growth – when growth in EPS
is achieved through mergers
with firms having low
P/E ratios
Procedures

Legal aspects
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The rules and regulations concerning
business combinations are outlined in:
 The Canadian Business Corporation Act
 Stock exchange regulations
The regulations provide shareholders the
information and opportunity to participate in
any final decision
The main federal issue looked at in mergers
and acquisitions is competition policy
Procedures

Friendly combinations
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Business combinations occur through friendly
negotiations between the management of the
two corporations or through a takeover bid
Major issues in the bargaining process include:
 price paid for the acquisition
 synergies created by combining the
companies
Procedures
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Tender offers
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tender offer – the acquiring firm bypasses
management and makes a direct offer to
shareholders of the targeted company
Management can fight unfriendly takeovers through:
1. legal barriers
2. poison pills
3. soliciting competing takeover bids from other firms
4. company changes making it less attractive to the
acquiring firm
5. counter-attacks
Procedures

Purchase of assets or shares
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External expansion can be accomplished
through:

purchasing another firms assets

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attractive when target has contingent
liabilities
gaining a firm’s control by purchasing
the company’s shares

in this case, both assets and liabilities
are taken over by the parent company
Public Policy Implications of
Business Combinations
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Public concerns over past and future
mergers include:
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corporate concentration and power
declining competition
foreign control and ownership
large debt loads restricting new investments
Summary
1. The combination of separate business
entities in the form of mergers,
amalgamations, and the use of holding
companies can achieve business expansion
externally for a firm. Ultimately, the driving
force behind any expansion should be a
creation of value that increases shareholder
wealth.
Summary
2. An acquisition should only be pursued if it
generates a positive net present value.
Estimated future cash flows that accrue as a
consequence of an acquisition should reflect
any actions that the new management may
implement, and the discount rate applied
should be commensurate with the target
firm’s perceived risk.
Summary
3. Business combinations affect reported
earnings per share (EPS), the shares’ priceearnings (P/E) ratio, and market price of the
surviving entity. EPS, however, may grow if
one firm acquires another whose shares trade
at a lower P/E ratio.
4. Net assets of the acquiring firms are revalued
to reflect the purchase price actually paid,
and incomes of the two businesses are
pooled as of the date of acquisition.
Summary
5. A combination may be arranged through
negotiations between management followed
by shareholder ratification or through a
tender offer. Reluctant management can
pursue a variety of strategies to fend off an
unfriendly takeover and to protect their own
interests.
6. A variety of statutes dictate the rules under
which a business combination may occur
because of economic concerns and past
abuses.