ONLINE CHAPTERS
To determine the effect of a merger on share price, it is important to consider not just the merger effects
on the level of earnings but also to consider whether the merger makes the company’s cash flows and
earnings riskier. Consider how the method of payment can affect earnings risk. If the acquiring company
issues a lot of debt and uses the principal as cash to acquire a target’s shares, then (assuming the target’s
profitability exceeds financing costs) the acquirer will increase its EPS via the acquisition, while the
number of shares outstanding will remain constant, so earnings per share will increase. In contrast,
the acquirer could instead issue its own shares to purchase the target’s equity. In this case, the effect
on earnings will be similar (we need to adjust for after-tax interest paid) but the number of shares will
increase because of the new shares issued, which will have an effect of reducing EPS in the shares
acquisition.
Does this mean that the first method (borrowing to obtain funds to make the purchase) is better than
the second method (increasing the number of shares to make the purchase) because it increases EPS
more? Not necessarily. As pointed out in Chapter 14, using debt levers up the transaction, splitting the
gains or losses over a smaller number of acquisition shares. While this may increase expected EPS, it
also increases the riskiness of EPS, which puts downward pressure on the share price and the P/E ratio.
If P/E falls while EPS increases, it is not clear that share valuation will also increase. Therefore, it is not
clear that a company’s share price will increase just because a deal is EPS accretive.
Having said this, we emphasise that EPS accretion is often desirable. If an acquisition increases
EPS because it cuts costs, increases revenue or otherwise increases net present value, these are positive
effects of the acquisition.CONCEPT REVIEW QUESTIONS 21-2
3 What characteristics surrounding a merger would lead you to conclude that it is motivated by
value-maximising managers rather than non-value-maximising managers?4 What different challenges and pressures might senior management of an acquirer face if the
acquiring company is a public versus a private company?5 Given that many conglomerate mergers and corporate diversification have proven to be failures,
why would any manager pursue these objectives? Can you think of any cases where corporate
diversification has worked successfully? What distinguishes these cases from the norm?21-3 DO MERGERS CREATE VALUE?
The previous section described proposed explanations of whether and how mergers might increase, or
destroy, company value. Only by looking at the data can we determine whether, on net, mergers actually
add value. In this section we demonstrate that, by and large, mergers do create value, but this gain accrues
almost entirely to target companies, with the shareholders of acquiring companies often losing money.
For mergers to create value, it must be the case that two companies combined are worth more than
the two companies are worth separately, once synergies and other merger gains and costs are considered.
One way to determine whether value is added is to compare the present value of all future cash flows
of the combined company to the sum of the value of bidder’s future cash flows plus the present value of
target’s future cash flows. This valuation, and several others, are discussed next.