20.9Financing Acquisitions

Major acquisitions are financed in a number of ways. When the acquiring firm

purchases the target with cash, it usually will have to borrow or issue new debt. Alter-

natively, the acquirer may purchase the target by offering target shareholders its own

stock in exchange for the target’s stock.

Astudy by Andrade, Mitchell, and Stafford (2001) documents changes in the

financing of mergers over the past 20 years. They found that in the 1970s and 1980s,

fewer than half of the acquirers used any of their company’s stock for acquisitions.

However, in the 1990s, about 71 percent of the acquisitions used some stock and 58

percent of the acquisitions were made exclusively with the acquiring firm’s stock.

In making the decision on how to finance an acquisition, managers should consider

the following:

1.Tax implications.

2.Accounting implications.

3.Capital structure implications.

4.Information effects.

Tax Implications of the Financing of a Merger or an Acquisition

In a merger, the acquiring firm must decide whether to offer stock, cash, or a combi-

nation of each for the shares of the target firm. The decision is often made because of

tax considerations. Three tax considerations can affect the choice:

•	The potential capital gains tax liability of the acquired firm’s shareholders.
•	The ability to write up the value of the purchased assets.
•	The tax gains from leverage.

The Capital Gains Tax Liability.All else being equal, the target shareholders gen-

erally prefer a stock offer to cash for tax reasons because they do not need to pay a

capital gains tax on the appreciation of their shares if they receive the acquirer’s stock

rather than cash for their shares. Moreover, they can still obtain cash by selling the

shares received from the acquiring firms. In a cash offer, they have no such option and

are forced to realize a taxable gain.

Since the shareholders of acquired firms may have a tax preference for equity-

funded acquisitions, one might expect them to require lower premiums for equity-funded

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Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

720Part VIncentives, Information, and Corporate Control

offers. The empirical evidence indicates that this is indeed true. Travlos (1987); Franks,

Harris, and Mayer (1988); and Huang and Walkling (1987) found that premiums in

equity-exchange offers are much lower than in cases where the shareholders of the

acquired firm are offered cash for their shares.¹⁵

Franks, Harris, and Mayer reported that

the differences in these premiums are reflected in a return to the acquired firm in the

announcement month of 25.4 percent for cash offers in the United States (30.2 percent

in the United Kingdom) and 11.1 percent for stock offers in the United States (15.1 per-

cent in the United Kingdom).

Stepping up the Basis before the Tax Act of 1986.From the acquiring firm’s per-

spective, the cash offer was preferred before 1986 because it allowed the firm to write up

the tax basis of the acquired firm’s assets, while an acquisition that used the acquiring

firm’s stock would not allow such an asset write-up. After 1986, the basis is stepped up

in a cash offer, but the associated capital gains liability more than outweighs the tax advan-

tage of the basis step-up for depreciation. (This was also noted earlier in this chapter.)

Accounting Implications of the Financing of a Merger or an Acquisition

If a merger is financed with an exchange of stock, it may qualify for pooling of inter-

ests accountingtreatment. This means thatthe items on the balance sheets of the two

firms are added together, and the merged firm’s reported income would simply be the

sum of the income of the two separate firms. For example, if Alpha has a book value

of $3 million and Beta has a book value of $2 million, then the merged firm, Alpha-

Beta, will have a book value of $5 million.

If an acquisition is made with cash, the acquisition must be treated as a purchase

of assets. Under the purchase method of accounting, the acquiring firm is assumed to

have purchased the assets of the acquired firm at the purchase price. As a result, if Alpha

purchases Beta for $3 million, the new book value of Beta’s assets will be $3million

rather than $2 million, with the additional $1 million reported on the merged firm’s

balance sheet as goodwill.

The choice between pooling and purchase accounting has no cash implications for

the merged firm, but it is of interest to managers because it affects reported earnings.

In the Wells Fargo merger with First Interstate Bank in 1995, a purchase accounting

transaction, earnings per share declined as a result of the accounting treatment. Aman-

ager involved in the merger told us that at least part of the $10 million in fees paid to

investment banks was compensation for convincing stock analysts that the drop in earn-

ings per share was due to the accounting treatment of the merger, not to some funda-

mental drop-off in the banking business of the merged firms.

The decline in earnings per share in a purchase transaction occurs because the addi-

tional goodwill generated on the merged firm’s balance sheet needs to be amortized,

over a period that cannot exceed 40 years. For example, in America Online’s 2000

acquisition of Time Warner, 87 percent of the purchase price was allocated to goodwill,

which was amortized over 25 years. Reported income is lower because the amortiza-

tion charges are deducted from reported income. If the $1 million in goodwill in the

hypothetical merger between Alpha and Beta was amortized over 40 years, the merged

firm’s reported income would be reduced by $25,000 in each of the following 40 years.

This change in reported income has no effect on the merged firm’s cash flows and

therefore should not affect market value. However, since various contracts such as bond

¹⁵This

also could reflect the fact that hostile offers are generally cash offers.

Grinblatt1454Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1454Hill
Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

Chapter 20

Mergers and Acquisitions

721

covenants and management compensation contracts may be based on reported income,

and since analysts are perceived by some firms as being confused about what the impact

of the accounting treatment on earnings should be, the accounting treatment of a merger

is likely to be of interest to a manager and may influence how a deal is structured.

Most acquirers prefer to use pooling accounting because it results in higher earn-

ings, but they also may want to realize the tax benefits from increased leverage that

would result from a cash offer. One might think that the acquirer could achieve the best

of both worlds either by repurchasing its own shares following the acquisition or by

having the target firm repurchase a substantial fraction of its shares prior to the merger.

However, a requirement that must be satisfied to qualify for pooling of interest account-

ing treatment is that the common equity interests of neither of the merged firms change

materially in the two years before and after the merger. Either of the preceding actions

would violate this requirement and force the acquirer to use the purchase of assets

accounting method. For example, the Wells Fargo/First Interstate Bank merger dis-

cussed above was financed by an exchange of stock but was treated as a purchase of

assets merger because the preceding requirement was not satisfied.

Aware of the perceived preference for pooling accounting treatment, potential tar-

get firms sometimes repurchase shares to deter unwanted hostile offers. In some of

these cases, target managers agree later to accept a more attractive offer, and then take

steps that allow the acquirer to use pooling of interest accounting. For example, the

target can undo the effects of a repurchase by reissuing the repurchased shares.

The Use of Pooling Accounting in AT&T’s Acquisition of NCR

AT&T’s $7.5 billion acquisition of NCR in 1991 illustrates the effect that accounting choices

can have on mergers. Lys and Vincent (1995) reported that in response to AT&T’s hostile

offer, NCR established an employee stock ownership plan (ESOP) that controlled approxi-

mately 8 percent of the firm’s common stock and declared a $1 per share special dividend.

Both of these actions qualified as changes in NCR’s equity interest, which precluded the

use of pooling accounting. NCR also had repurchased shares in 1989 and 1990 which also

would be a problem.

AT&Twas concerned about the effect of the acquisition on the firm’s reported earnings

if it was forced to use purchase accounting. Lys and Vincent estimated that if AT&Tand

NCR were combined with pooling accounting, the earnings per share would have been $2.42

in 1990, but with purchase accounting, the reported earnings per share would have been

only $1.97. It should be stressed, however, that this difference in reported earnings would

have had no effect on AT&T’s taxable income and it would not affect its cash flows.

After AT&Tincreased its offer, NCR management agreed to be taken over. Part of the

increase was specifically tied to steps that NCR needed to take to satisfy the requirements

for pooling of interest accounting. For example, The Wall Street Journalreported on March

25, 1991, that AT&Twas willing to pay “another $5 a share if AT&Tpays in stock and can

treat the acquisition as a pooling of interests, avoiding certain accounting charges.”

To satisfy the conditions for pooling of interest accounting treatment, NCR had to cut

its regular dividend, to offset the prior special dividend, and reissue the shares that were

previously repurchased. Lys and Vincent estimated that the transaction cost of reissuing the

shares was about $50 million and that AT&Twas forced to pay an additional $450 million in

order to get NCR management to make the changes that allowed them to adopt pooling of

interest accounting. Apparently, AT&Tplaced a very high value on having what it considered

the more favorable accounting treatment which pooling of interest accounting provided.

The End of Pooling and Goodwill Amortization.On June 29, 2001, FASB took a

final vote to eliminate pooling of interest accounting for business combinations. All

mergers after June 30, 2001, now have to be accounted for using the purchase method.

However, the goodwill that is generated from these purchases will not be amortized.

Grinblatt1456Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1456Hill
Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

722Part VIncentives, Information, and Corporate Control

This change is likely to have an important effect on the financing choices of firms that

are likely to be involved in mergers:

1.We might expect to observe more cash-financed mergers since cash and stock

financed mergers are put on an even footing under this proposal.

2.Firms might choose to forego some mergers that would be implemented under

pooling accounting because under the new purchase accounting rules, the

book values of tangible assets, such as building and equipment, will be

written up, resulting in additional depreciation and lower reported earnings.

3.Firms that are likely to be involved in mergers will be more willing to

repurchase shares since they will no longer be concerned about qualifying for

pooling.

Capital Structure Implications in the Financing of a Merger or an Acquisition

The financing of a takeover is partially determined by its effect on the firm’s overall

capital structure. As Chapter 17 discussed, firms that made profitable cash-generating

investments in that past, but which have few profitable new investment opportunities,

tend to use their cash to pay down debt and become underleveraged over time. Section

20.4 mentioned that firms in these situations often finance acquisitions with debt to

move toward their long-run optimal debt ratio. However, firms that are overleveraged,

perhaps because of previous debt-financed acquisitions, may have an incentive to

finance new acquisitions by exchanging stock.