КФ / Лекции / Brealey Myers - Principles Of Corporate Finance 7th Ed (eBook)

However, suppose that B’s share price has already risen $12 because of rumors that B might get a favorable merger offer. That means that its intrinsic value is overstated by 12 500,000 $6 million. Its true value, PVB, is only $44 million. Then

Cost 165 442 $21 million

Since the merger gain is $25 million, this deal still makes A’s stockholders better off, but B’s stockholders are now capturing the lion’s share of the gain.

Notice that if the market made a mistake, and the market value of B was less than B’s true value as a separate entity, the cost could be negative. In other words, B would be a bargain and the merger would be worthwhile from A’s point of view, even if the two firms were worth no more together than apart. Of course, A’s stockholders’ gain would be B’s stockholders’ loss, because B would be sold for less than its true value.

Firms have made acquisitions just because their managers believed they had spotted a company whose intrinsic value was not fully appreciated by the stock market. However, we know from the evidence on market efficiency that “cheap” stocks often turn out to be expensive. It is not easy for outsiders, whether investors or managers, to find firms that are truly undervalued by the market. Moreover, if the shares are bargain-priced, A doesn’t need a merger to profit by its special knowledge. It can just buy up B’s shares on the open market and hold them passively, waiting for other investors to wake up to B’s true value.

If firm A is wise, it will not go ahead with a merger if the cost exceeds the gain. Conversely, firm B will not consent to a merger if it thinks the cost to A is negative, for a negative cost to A means a negative gain to B. This gives us a range of possible cash payments that would allow the merger to take place. Whether the payment is at the top or the bottom of this range depends on the relative bargaining power of the two participants.

Estimating Cost When the Merger Is Financed by Stock

In recent years about 70 percent of mergers have involved payment wholly or partly in the form of the acquirer’s stock. When a merger is financed by stock, cost depends on the value of the shares in the new company received by the shareholders of the selling company. If the sellers receive N shares, each worth PAB, the cost is

Cost N PAB PVB

Just be sure to use the price per share after the merger is announced and its benefits are appreciated by investors.

Suppose that A offers 325,000 (.325 million) shares instead of $65 million in cash. A’s share price before the deal is announced is $200. If B is worth $50 million standalone,17 the cost of the merger appears to be

Apparent cost .325 200 50 $15 million

However, the apparent cost may not be the true cost. A’s stock price is $200 before the merger announcement. At the announcement it ought to go up.

Given the gain and the terms of the deal, we can calculate share prices and market values after the deal. The new firm will have 1.325 million shares outstanding

17In this case we assume that B’s stock price has not risen on merger rumors and accurately reflects B’s stand-alone value.

and will be worth $275 million.18 The new share price is 275/1.325 $207.55. The true cost is

Cost .325 207.55 50 $17.45 million

This cost can also be calculated by figuring out the gain to B’s shareholders. They end up with .325 million shares, or 24.5 percent of the new firm AB. Their gain is

.24512752 50 $17.45 million

In general, if B’s shareholders are given the fraction x of the combined firms,

Cost xPVAB PVB

We can now understand the first key distinction between cash and stock as financing instruments. If cash is offered, the cost of the merger is unaffected by the merger gains. If stock is offered, the cost depends on the gains because the gains show up in the postmerger share price.

Stock financing also mitigates the effect of overvaluation or undervaluation of either firm. Suppose, for example, that A overestimates B’s value as a separate entity, perhaps because it has overlooked some hidden liability. Thus A makes too generous an offer. Other things being equal, A’s stockholders are better off if it is a stock offer rather than a cash offer. With a stock offer, the inevitable bad news about B’s value will fall partly on the shoulders of B’s stockholders.

Asymmetric Information

There is a second key difference between cash and stock financing for mergers. A’s managers will usually have access to information about A’s prospects that is not available to outsiders. Economists call this asymmetric information.

Suppose A’s managers are more optimistic than outside investors. They may think that A’s shares will really be worth $215 after the merger, $7.45 higher than the $207.55 market price we just calculated. If they are right, the true cost of a stockfinanced merger with B is

Cost .325 215 50 $19.88

B’s shareholders would get a “free gift” of $7.45 for every A share they receive—an extra gain of $7.45 .325 2.42, that is, $2.42 million.

Of course, if A’s managers were really this optimistic, they would strongly prefer to finance the merger with cash. Financing with stock would be favored by pessimistic managers who think their company’s shares are overvalued.

Does this sound like “win-win” for A—just issue shares when overvalued, cash otherwise? No, it’s not that easy, because B’s shareholders, and outside investors generally, understand what’s going on. Suppose you are negotiating on behalf of B. You find that A’s managers keep suggesting stock rather than cash financing. You quickly infer A’s managers’ pessimism, mark down your own opinion of what the shares are worth, and drive a harder bargain.

18In this case no cash is leaving the firm to finance the merger. In our example of a cash offer, $65 million would be paid out to B’s stockholders, leaving the final value of the firm at 275 65 $210 million. There would only be one million shares outstanding, so share price would be $210. The cash deal is better for A’s shareholders.

This asymmetric-information story explains why buying-firms’ share prices generally fall when stock-financed mergers are announced.19 Andrade, Mitchell, and Stafford found an average market-adjusted fall of 1.5 percent on the announcement of stock-financed mergers between 1973 and 1998. There was a small gain (.4 percent) for a sample of cash-financed deals.20

33.4 THE MECHANICS OF A MERGER

Buying a company is a much more complicated affair than buying a piece of machinery. Thus we should look at some of the problems encountered in arranging mergers. In practice, these problems are often extremely complex, and specialists must be consulted. We are not trying to replace those specialists; we simply want to alert you to the kinds of legal, tax, and accounting issues they deal with.

Mergers and Antitrust Law

Mergers can get bogged down in the federal antitrust laws. The most important statute here is the Clayton Act of 1914, which forbids an acquisition whenever “in any line of commerce or in any section of the country” the effect “may be substantially to lessen competition, or to tend to create a monopoly.”

Antitrust law can be enforced by the federal government in either of two ways: by a civil suit brought by the Justice Department or by a proceeding initiated by the Federal Trade Commission (FTC).21 The Hart–Scott–Rodino Antitrust Act of 1976 requires that these agencies be informed of all acquisitions of stock amounting to $15 million or 15 percent of the target’s stock, whichever is less. Thus, almost all large mergers are reviewed at an early stage.22 Both the Justice Department and the FTC then have the right to seek injunctions delaying a merger. Often this injunction is enough to scupper the companies’ plans.

Both the FTC and the Justice Department have been flexing their muscles in recent years. Here is an example. After the end of the Cold War, sharp declines in defense budgets triggered consolidation in the U.S. aerospace industry. By 1998 there remained just three giant companies—Boeing, Lockheed Martin, and Raytheon— plus several smaller ones, including Northrup Grumman. Thus, when Lockheed Martin and Northrup Grumman announced plans to get together, the Departments of Justice and Defense decided that this was a merger too far. In the face of this opposition, the two companies broke off their engagement.

19The same reasoning applies to stock issues. See Sections 15.4 and 18.4.

20See G. Andrade, M. Mitchell, and E. Stafford, “New Evidence and Perspectives on Mergers,” Journal of Economic Perspectives 15 (Spring 2001), pp. 103–120. This result confirms earlier work by Travlos and by Franks, Harris, and Titman. See N. Travlos, “Corporate Takeover Bids, Methods of Payment, and Bidding Firms’ Stock Returns,” Journal of Finance 42 (September 1987), pp. 943–963; and J. R. Franks, R. S. Harris, and S. Titman, “The Postmerger Share-Price Performance of Acquiring Firms,” Journal of Financial Economics 29 (March 1991), pp. 81–96.

21Competitors or third parties who think they will be injured by the merger can also bring antitrust suits.

22The target has to be notified also, and it in turn informs investors. Thus the Hart–Scott–Rodino Act effectively forces an acquiring company to “go public” with its bid.

are two ways of doing this. First, the acquirer can seek the support of the target firm’s stockholders at the next annual meeting. This is called a proxy fight because the right to vote someone else’s share is called a proxy.27

Proxy fights are expensive and difficult to win. The alternative for the would-be acquirer is to make a tender offer directly to the shareholders. The management of the target firm may advise its shareholders to accept the tender, or it may attempt to fight the bid.

Tender battles resemble a complex game of poker. The rules are set mostly by the Williams Act of 1968, by state law, and by the courts. The problem in setting the rules is that it is unclear who requires protection. Should the management of the target firm be given more weapons to defend itself against unwelcome predators? Or should it simply be encouraged to sit the game out? Or should it be obliged to conduct an auction to obtain the highest price for its shareholders? And what about would-be acquirers? Should they be forced to reveal their intentions at an early stage, or would that allow other firms to piggy-back on their good ideas and enter competing bids?28

Keep these questions in mind as we review one of the more interesting chapters in merger history.

Boone Pickens Tries to Take Over Cities Service, Gulf Oil, and Phillips Petroleum

The 1980s saw a series of pitched takeover battles in the oil industry. The most interesting and visible player in these battles was Boone Pickens, chairman of Mesa Petroleum and a self-styled advocate for shareholders everywhere. Pickens and Mesa didn’t win many battles, but they made a lot of money losing them, and they helped force major changes in oil companies’ investment and financing policies.

Mesa’s attack on Cities Service29 illustrates Pickens’s modus operandi. The battle began in May 1982, when Mesa bought Cities shares in preparation for a takeover bid. Cities counterattacked. It issued more shares to dilute Mesa’s holdings, and it made a retaliatory offer for Mesa. (This is called a pacman defense—try to take over the attacker before it takes over you!) Over the following month Mesa upped its bid for Cities, and Cities twice increased its bid for Mesa. But in the end Cities won: Mesa agreed to call off its bid and not to make another one for Cities for at least five years. In exchange, Cities agreed to repurchase Mesa’s holdings at an $80 million profit to Mesa. This is called a greenmail payment.

Though Cities escaped Mesa, it was still in play. It looked for a white knight, that is, a friendly acquirer, and found one in Gulf Oil. But the Federal Trade Commission raised various objections to that deal, and Gulf backed out.

In the end, Cities was bought by Occidental Petroleum. Occidental made a tender offer of $55 per share in cash for 45 percent of Cities, followed by a package of fixed income securities for the remaining stock. This is called a two-tier offer. In effect, Occidental was saying, “Last one through the door does the washing up.”

27Peter Dodd and Jerrold Warner have written a detailed description and analysis of proxy fights. See “On Corporate Governance: A Study of Proxy Contests,” Journal of Financial Economics 2 (April 1985), pp. 401–438.

28The Williams Act obliges firms who own 5 percent or more of another company’s shares to tip their hand by reporting their holding in a Schedule 13(d) filing with the SEC.

29See R. S. Ruback, “The Cities Service Takeover: A Case Study,” Journal of Finance 38 (May 1983), pp. 319–330.

Almost all Cities stockholders rushed to take advantage of the cash offer, and Occidental gained control.

One year after its brief engagement with Cities, Gulf itself became a takeover target. Pickens and Mesa were again on the warpath. At this point Chevron came to the rescue and acquired Gulf for $13.2 billion, more than double its value six months earlier. Chevron’s bid gave Mesa a profit of $760 million on the Gulf shares it had bought. Asked for his views, Pickens commented, “Shucks, I guess we lost another one.”

But why was Gulf worth that much more to Chevron than to investors just a few months earlier? Where was the added value? The answer will emerge as we look at Pickens’s next foray, against Phillips Petroleum.

By 1984 Mesa had accumulated 6 percent of Phillips at an average price of $38 per share and made a bid for a further 15 percent at $60 per share. Phillips’s first response was predictable: It bought out Mesa’s shareholding. This greenmail payment gave Mesa a profit of $89 million.30

The other two responses reveal why Phillips was such an attractive target. It raised its dividend by 25 percent, reduced capital spending, and announced a program to sell $2 billion of assets. It also agreed to repurchase about 50 percent of its stock and to issue instead $4.5 billion of debt. Table 33.5 shows how this leveraged repurchase changed Phillips’s balance sheet. The new debt ratio was about 80 percent, and book equity shrank by $5 billion to $1.6 billion.

This massive debt burden put Phillips on a strict cash diet. It was forced to sell assets and pinch pennies wherever possible. Capital expenditures were cut back from $1,065 million in 1985 to $646 million in 1986. In the same years, the number of employees fell from 25,300 to 21,800. Austerity continued through the late 1980s.

How did this restructuring shield Phillips from takeover? Certainly not by making purchase of the company more expensive. On the contrary, restructuring drastically reduced the total market value of Phillips’s outstanding stock and therefore reduced the likely cost of buying out its remaining shareholders.

But restructuring removed the chief motive for takeover, which was to force Phillips to generate and pay out more cash to investors. Before the restructuring, investors sensed that Phillips was not running a tight ship and worried that it would plow back its ample operating cash flow into mediocre capital investments or ill-advised expansion. They wanted Phillips to pay out its free cash flow rather than let it be soaked up by a too-comfortable organization or plowed into negative-

30Giving in to greenmail can be dangerous, as Phillips soon discovered. Just six weeks later another corporate raider, Carl Icahn, acquired nearly 5 percent of Phillips stock and made an offer for the remainder. Phillips responded with a second greenmail payment, buying out Icahn and his pals for a profit (to them) of about $35 million.

NPV investments. Consequently, Phillips’s share price did not reflect the potential value of its assets and operations. That created the opportunity for a takeover. One can almost hear the potential raider thinking:

So what if I have to pay a 30 or 40 percent premium to take over Phillips? I can borrow most of the purchase price and then pay off the loan by selling surplus assets, cutting out all but the best capital investments, and wringing out slack in the organization. It’ll be a rough few years, but if surgery’s necessary, I might as well be the doctor and get paid for doing it.

Phillips’s managers did not agree that the company was slack or prone to overinvestment. Nevertheless, they bowed to pressure from the stock market and undertook the surgery themselves. They paid out billions to repurchase stock and to service the $6.5 billion in long-term debt. They sold assets, cut back capital investment, and put their organization on the diet investors were calling for.

There are two lessons here. First, when the merger motive is to eliminate inefficiency or to distribute excess cash, the target’s best defense is to do what the bidder would do, and thus avoid the cost, confusion, and random casualties of a takeover battle. Second, you can see why a company with ample free cash flow can be a tempting target for takeover.

The oil industry entered the 1980s with more-than-ample free cash flow. Rising oil prices had greatly increased revenues and operating profits. Investment opportunities had not expanded proportionately. Many companies overinvested. Investors foresaw massive, negative-NPV outlays and marked down the companies’ stock prices accordingly. This created the opportunity for takeovers. Pickens and other acquirers could afford to offer a premium over the prebid stock price, knowing that if they did gain control they could increase value by putting the target company on a diet.

Pickens never succeeded in taking over a major oil company, but he and other “raiders” helped force the industry to cut back investment, reduce operating costs, and return cash to investors. Much of the cash was returned by stock repurchases.

Takeover Defenses

The Cities Service case illustrates several tactics managers use to fight takeover bids. Frequently they don’t wait for a bid before taking defensive action. Instead, they deter potential bidders by devising poison pills that make their companies unappetizing or they persuade shareholders to agree to shark-repellent changes to the company charter.31 Table 33.6 summarizes the principal first and second levels of defense.

Why do managers contest takeover bids? One reason is to extract a higher price from the bidder. Another possible reason is that managers believe their jobs may be at risk in the merged company. These managers are not trying to obtain a better price; they want to stop the bid altogether.

Some companies reduce these conflicts of interest by offering their managers golden parachutes, that is, generous payoffs if the managers lose their jobs as the result of a takeover. It may seem odd to reward managers for being taken over. However, if a soft landing overcomes their opposition to takeover bids, a few million dollars may be a small price to pay.

31Since shareholders expect to gain if their company is taken over, it is no surprise that they do not welcome these impediments. See, for example, G. Jarrell and A. Poulsen, “Shark Repellents and Stock Prices: The Effects of Antitakeover Amendments since 1980,” Journal of Financial Economics 19 (1987), pp. 127–168.

Preoffer Defenses

Shark-repellent charter amendments:

Staggered board The board is classified into three equal groups. Only one group is elected each year. Therefore the bidder cannot gain control of the target immediately.

T A B L E 3 3 . 6

A summary of takeover defenses.

Source: This table is loosely adapted from R. S. Ruback, “An Overview of Takeover Defenses,” working paper no. 1836–86, Sloan School of Management, MIT, Cambridge, MA, September 1986, tables 1 and 2. See also L. Herzel and R. W. Shepro, Bidders and Targets: Mergers and Acquisitions in the U.S., Basil Blackwell, Inc., Cambridge, MA, 1990, chap. 8.

Any management team that tries to develop improved weapons of defense must expect challenge in the courts. In the early 1980s the courts tended to give managers the benefit of the doubt and respect their business judgment about whether a takeover should be resisted. But the courts’ attitudes to takeover battles have changed. For example, in 1993 a court blocked Viacom’s agreed takeover of Paramount on the grounds that Paramount’s directors did not do their homework before turning down a higher offer from QVC. Paramount was forced to give up its poison-pill defense and the stock options that it had offered to Viacom. Because of such decisions, managers have become much more careful in opposing bids, and they do not throw themselves blindly into the arms of any white knight.32

At the same time, state governments have provided some new defensive weapons. In 1987 the Supreme Court upheld state laws that allow companies to deprive an investor of voting rights as soon as the investor’s share in the company ex-

32In 1985 a shiver ran through many boardrooms when the directors of Trans Union Corporation were held personally liable for being too hasty in accepting a takeover bid. Changes in judicial attitudes to takeover defenses are reviewed in L. Herzel and R. W. Shepro, Bidders and Targets: Mergers and Acquisitions in the U.S., Basil Blackwell, Inc., Cambridge, MA, 1990.