Principles of Corporate Finance_ 12th Edition

❱ TABLE 31.3^

Accounting for

the merger of A

Corporation and

B Corporation

assuming that A

Corporation pays

$18 million for B

Corporation (figures

in $ millions).

Key: NWC = net work-

ing capital; FA = net

book value of fixed

assets; D = debt; E = book

value of equity.

Balance Sheet of AB Corporation

NWC 21 30 D

FA 89 88 E

Goodwill 8

118 118

Balance Sheet of A Corporation

NWC 20 30 D

FA 80 70 E

100 100

Balance Sheet of B Corporation

NWC 1 0 D

FA 9 10 E

10 10

828 Part Ten Mergers, Corporate Control, and Governance

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Economic nationalism is not confined to Europe. In 2006, Congress voiced its opposition

to the takeover of Britain’s P&O by the Dubai company DP World. The acquisition went

ahead only after P&O’s ports in the United States were excluded from the deal. And in the

wake of concern over cyber espionage, a U.S. House of Representatives committee recom-

mended in 2012 that the federal government should block mergers of U.S. firms with Chinese

telecommunications companies.

The Form of Acquisition

Suppose you are confident that the purchase of company B will not be challenged on antitrust

grounds. Next you will want to consider the form of the acquisition.

One possibility is literally to merge the two companies, in which case one company auto-

matically assumes all the assets and all the liabilities of the other. Such a merger must have

the approval of at least 50% of the stockholders of each firm.^17

An alternative is simply to buy the seller’s stock in exchange for cash, shares, or other

securities. In this case the buyer can deal individually with the shareholders of the selling

company. The seller’s managers may not be involved at all. Their approval and cooperation

are generally sought, but if they resist, the buyer will attempt to acquire an effective majority

of the outstanding shares. If successful, the buyer has control and can complete the merger

and, if necessary, toss out the incumbent management.

The third approach is to buy some or all of the seller’s assets. In this case ownership of the

assets needs to be transferred, and payment is made to the selling firm rather than directly to

its stockholders.

Merger Accounting

When one company buys another, its management worries about how the purchase will show

up in its financial statements. Before 2001 the company had a choice of accounting method,

but in that year the Financial Accounting Standards Board (FASB) introduced new rules that

required the buyer to use the purchase method of merger accounting. This is illustrated in

Table 31.3, which shows what happens when A Corporation buys B Corporation, leading to

the new AB Corporation. The two firms’ initial balance sheets are shown at the top of the

table. Below this we show what happens to the balance sheet when the two firms merge. We

assume that B Corporation has been purchased for $18 million, 180% of book value.

(^17) Corporate charters and state laws sometimes specify a higher percentage.