Introduction to Corporate Finance

(avery) #1
Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition

VIII. Topics in Corporate
Finance


  1. Mergers and
    Acquisitions


© The McGraw−Hill^877
Companies, 2002

purchasing fixed-income securities, the firm has several ways to spend the free cash
flow, including:



  1. Paying dividends

  2. Buying back its own shares

  3. Acquiring shares in another firm


We discussed the first two options in Chapter 18. We saw that an extra dividend will
increase the income tax paid by some investors. A share repurchase will reduce the taxes
paid by shareholders as compared to paying dividends, but this is not a legal option if
the sole purpose is to avoid taxes that would have otherwise been paid by shareholders.
To avoid these problems, the firm can buy another firm. By doing this, the firm
avoids the tax problem associated with paying a dividend. Also, the dividends received
from the purchased firm are not taxed in a merger.


Asset Write-Ups We have previously observed that, in a taxable acquisition, the as-
sets of the acquired firm can be revalued. If the value of the assets is increased, tax de-
ductions for depreciation will be a benefit, but this benefit will usually be more than
offset by taxes due on the write-up.


Reductions in Capital Needs


All firms must make investments in working capital and fixed assets to sustain an effi-
cient level of operating activity. A merger may reduce the combined investments needed
by the two firms. For example, it may be that Firm A needs to expand its manufacturing
facilities whereas Firm B has significant excess capacity. It may be much cheaper for
Firm A to buy Firm B than to build from scratch.
In addition, acquiring firms may see ways of more effectively managing existing as-
sets. This can occur with a reduction in working capital resulting from more efficient
handling of cash, accounts receivable, and inventory. Finally, the acquiring firm may
also sell off certain assets that are not needed in the combined firm.
Firms will often cite a large number of reasons for merging. Typically, when firms
agree to merge, they sign an agreement of merger,which contains, among other things,
a list of the economic benefits that shareholders can expect from the merger. For exam-
ple, the U.S. Steel and Marathon Oil agreement stated (emphasis added):


U.S. Steel believes that the acquisition of Marathon provides U.S. Steel with an attractive
opportunity to diversifyinto the energy business. Reasons for the merger include, but are not
limited to, the facts that consummation of the merger will allow U.S. Steel to consolidate
Marathon in U.S. Steel’s federal income tax return,will also contribute to greater efficiency,
and will enhance the ability to manage capitalby permitting movements of cash between
U.S. Steel and Marathon. Additionally, the merger will eliminate the possibility of conflicts
of interestbetween the interests of minority and majority shareholders and will enhance
management flexibility.The acquisition will provide Marathon shareholders with a substan-
tial premium over historic market prices for their shares. However, [Marathon] shareholders
will no longer continue to share in the future prospects of the company.

Avoiding Mistakes


Evaluating the benefit of a potential acquisition is more difficult than a standard capital
budgeting analysis because so much of the value can come from intangible, or otherwise
difficult to quantify, benefits. Consequently, there is a great deal of room for error. Here
are some general rules that should be remembered:


CHAPTER 25 Mergers and Acquisitions 853
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