Introduction to Corporate Finance

ONLINE CHAPTERS

explanations of mergers are more ominous. We already mentioned the empire-building tendencies that

are sometimes linked to upper management.

Roll (1986) offers a somewhat different rationale with his overconfidence or hubris hypothesis of

corporate takeovers. Roll contends that some managers overestimate their own managerial capabilities and

pursue takeovers in the belief that they can better manage their target than can its current management

team. Acquiring managers then overbid for the target and fail to realise the expected post-merger gains,

thereby diminishing shareholder wealth. Thus, the intent of the managers is not contrary to the best

interests of shareholders (the managers think they will create value), but the result is still value decreasing.

example

Let’s say Peanut Butter Pty Ltd decides to buy Jam Sandwiches Co. for $100 million. The deal should generate

cost savings because both companies have similar retail markets and can tap the marketing and distribution

channels of the other. Also, people tend to pay more for peanut butter and jam sandwiches than they would

for each product individually.

Peanut Butter has 10 million shares outstanding and an annual net income of $50 million, so EPS is

$5. Peanut Butter’s current share price is $100. Jam has 5 million shares outstanding and annual net income

of $15 million.

After-tax synergies: The merger results in savings of around $5 million annually. Additionally, because of

increased demand due to the popularity and convenience of premade peanut butter and jam sandwiches,

Peanut Butter’s bankers estimate additional synergies of $2.14 million. Total pre-tax synergies are therefore

$7.14 million. At a tax rate of 30%, after-tax synergies are $5 million.

Financing the acquisition: Of the $100 million purchase price, assume Peanut Butter pays Jam’s

shareholders with $50 million in cash, and $50 million in Peanut Butter shares. This involves:

1 Issuing $30 million in new debt. At 10% yield to maturity, this will result in annual interest payments of $3.0

million each year. For simplicity, we are assuming that the new debt is perpetual (it never retires).

2 Withdrawing $20 million in corporate cash, which was originally earning 5% per year.

3 Issuing 600,000 new shares at $100 each. Use $50 million of the proceeds to pay Jam’s shareholders, and

the remainder to retire $10 million of Jam’s debt, which incurred annual interest at a rate of 6.7% per year.

This results in annual interest expense savings of $1.5 million, or $1.05 million in after-tax savings (because

interest expense is tax deductible, creating a tax shield of $450,000 = $1.5 m × 30%).

Adjustments:

1 After-tax depreciation and amortisation from write-ups: As a result of the merger, Peanut Butter will be

taking over four of Jam’s plants. Equipment in the plant was purchased for around $30.0 million, but is

valued at $45.4 million in the takeover. The difference of $15.4 million is known as a write-up. Assuming

that Peanut Butter is able to depreciate this over 10 years, it can deduct depreciation of $1.54 million

per year. Applying a 30% tax rate, this translates to after-tax depreciation from write-ups of around $1.08

million a year.

2 After-tax interest expense because of new financing: New financing results in annual interest expense of

$3.0 million per year. After-tax annual interest expense is therefore $2.10 million a year (30% tax rate).

3 Opportunity cost of cash balances: The $20 million used to pay for the acquisition could have been earning

5%, or $1 million a year pre-tax, $700,000 per year after-tax.

4 Add interest expense associated with target’s debt that is retired: Saving $1.05 million in after-tax interest

expense will increase earnings going forward.

Total adjustments = – $1.08 million – $2.10 million – $700,000 + $1.05 million = –$2.83 million

thinking cap

question

Does the interest that a

company has to pay if it uses

debt to finance an acquisition

affect EPS? If so, does the

effect dilute earnings or is it

accretive?

hubris hypothesis of

corporate takeovers

A theory that contends that

some managers overestimate

their own managerial

capabilities and pursue

takeovers with the belief

that they can better manage

their takeover target than the

target’s current management