ANSWER 1
(a)Reasons why acquisitions often fail to enhance shareholder’s value:
• Hubris hypothesis – Errors in valuing a target firm.
• Market irrationality – If a rational manager observes that their firm’s stocks are
overvalued in the short run, they have an incentive to exchange the overvalued
stocks for real assets before the market corrects the overvaluation. A merger,
therefore, occurs to take advantage of the market irrationality and is not related to
either synergies or better management.
• Pre-eruptive theory – The theory explains why acquiring firms pursue valuedecreasing horizontal mergers even if managers are rational and are trying to
maximize shareholders value.
• Window dressing – Acquisition in order to present a better financial picture in the
short term.
QUESTION 2
Examine four strategies that a company could adopt to defend itself against a hostile
takeover.
Defensive strategies in a hostile takeover:
| – | Greenmail This involves preparing a shareholder-friendly charter that bans targeted share |
repurchases. In this case, a company has a right to make a counter offer to a bidder
only and not from any other shareholders. The raider also signs a document
promising not to attempt to take over the company, for a specified number of years,
hence the buyback also is call greenmail.
– Restricted voting rights
This is a provision which deprives a shareholder of voting rights if the shareholder
owns more than a specified amount of stock.
– The crown jewel strategy
A central theme in this strategy is the divestitures of major operating units most
coveted by the bidder (the crown jewel). A hostile bidder is deprived of the primary
intention behind the takeover bid. A variation of this method is the “scorched earth
approach” where the target sells off not only the crown jewel but also other properties
in order to diminish its worth.
| – | The “Packman” defence Under this strategy, the target company attempts to purchase the shares of the |
predator company. This is usually the scenario if the predator company is smaller
than the target company and the target company has a substantial resources.
| – | Staggered board In this case, a board is constituted that is made up of different classes of directors |
(usually three) with each class serving different terms. Staggered boards provide a
solid defence against hostile acquirers.
| – | Golden parachutes Golden parachutes refer to the “separation” clauses of an employment contract that |
compensates managers who lose their jobs under a change of management scenario.
The provision usually calls for a lump-sum abnormal payment.
| Poison Pill The target company will acquire huge loans that will scare a predator company. |
QUESTION 3
Summarize three assumptions of the Grossman-Hart Model (1986)
The following are the assumptions of the Grossman-hart Model (1996):
– There is no difference between ownership and control. Virtually, ownership is the
power to exercise control
– There is no distinction between employees and outside contractors in the case in
which the firm provides all the tools and other assets used by the contractor.
– The relationship which may be either vertical or lateral is assumed to last for 2
periods. In the first period, the manager of each firm makes relationship – specific
investments, while in the second period, some further production decisions are taken
and the benefits from the relationship are realized.
– Investments by managers 1 and 2 are chosen simultaneously and non-cooperatively.
– There is a competitive market in identical potential trading partners at date 0.
All variables are ex-ante non-contractible
QUESTION 4
Evaluate four advantages of employing organic growth strategies.
The organic growth strategy relies on developing a company’s internal resources and
capabilities. The advantages of this strategy are as follows:
⎯ Less risk than external growth (e.g. through mergers and takeovers).
⎯ Can be financed through internal funds (e.g. retained profits).
⎯ Builds on a business’ existing strengths (e.g. brands, customers).
⎯ Allows the business to grow at a more sensible rate in the long run.
⎯ This strategy ensures strategic independence. This means that a company does not
need to make the same compromises as might be necessary in an alliance for
example, which is likely to involve constraints on certain activities and may limit
future strategic choices.
⎯ Through culture management, new activities can be created in the existing cultural
environment which reduces the risk of culture clash-a common difficulty with
mergers, acquisitions and alliances.
⎯ This strategy helps to spread investment over time, which allows a reduction of
upfront commitment, making it easier to reverse or adjust strategy conditions
change.
⎯ There are no availability constraints which mean that the company is not dependent
on the availability of suitable acquisition targets or potential alliance partners. It is
also not necessary to wait for perfectly matched target to come on to the market.
It improves the company’s knowledge through direct involvement in the new market
or technology, thus providing deeper fast hand knowledge that is likely to be
internalised in the company rather than it working through a partner in the handsoff strategic alliances.
ANSWER 5
a) Explain the following methods of co-restructuring and state the
circumstances under which each is appropriate.
i) Sell-offs
It is also known as a divestiture. It is an outright sale of a company’s subsidiary. It’s
done when a subsidiary does not fit into the parent company’s core strategy and the
market may be undervaluing the combined business due to lack of synergy between
the parent and the subsidiary.
Sell-offs can also be used to raise cash which can be used to pay debts and
enhance/expand the existing business.
ii) Carve-outs
It is done by the parent company making a subsidiary public through an initial
public offering (IPO). A new publicly listed company is created but the parent
company keeps the controlling skate. This is done by a company when one of its
subsidiaries is growing faster and carrying a higher valuation than other businesses
owned by the parent. Apart from generating cash, the issue also unlocks the value
of the subsidiary unit thus enhancing the parent’s shareholders value.
| iii) | Spin-offs These occur when a subsidiary becomes an independent entity by parent company |
distributing its shares to its shareholders through a stock dividend. It is not likely
to be used if the firm needs to finance growth since no cash is generated.
Spin-offs are usually about unlocking hidden shareholders value. For the parent
company, it sharpens management focus.
QUESTION 6
Explain four reasons why mergers and acquisitions fail.
Reasons why mergers and acquisitions fail
⎯ Lack of clarity and execution of the integration process.
⎯ Cultural integration issues.
⎯ Negotiation errors like cases of overpaying for an acquisition.
⎯ External factors and changes to business environment e.g. where the new company
is forced by pressure groups to lay off workers.
⎯ Poor communication to all stakeholders of the merging entities.
⎯ Focusing on how the merger or acquisition will increase size of, the company and
not how it will create value for shareholders.
⎯ High acquisition price. This usually arises from an overestimation or miscalculation
of the potential payoffs arising from the merger.
Lack of enough effort being expanded on the due diligence process or screening of
the target company.
ANSWER 7
(i) Explain the term “value gaps” as used in mergers.
Value gaps
These arise from the fact that market values of firms to be acquired typically fall short
of the value that potential or actual bidders would place on them thus shareholders of
target companies mostly experience a beneficial wealth effect.
(ii) Reasons why value gaps arise in mergers
Over-enthusiastic bidding – Assessments of the bidding company management may
not have been correct or shrouded by other reasons such as development.
Stock market inefficiency – The market may fail to assess the full value of a business
because it is “out of favour”
Poor financial management – The headquarters may be following poor financing or
dividend policies.
QUESTION 8
Briefly explain four strategies which might be open to a company intending to
avoid being acquired by another company.
Avoiding being taken over strategies
Divestiture –The target firms spins off some of its business into an independent
subsidiary company thus reducing its attractiveness to the predator.
Golden parachutes – these are provisions in contracts. They state that they will
get a large bonus in cash/stock if the company is acquired.
Crown jewels – Sale of target company’s valuable divisions in order for it to be
attractive.
White knight- the target finds another company to acquire it.
PAC –MAN defence-target Company goes for takeover by buying stocks in the
acquiring company i.e. it gives a counter offer.
ANSWER 9
(a)Four reasons behind failed mergers
⎯ Failure to manage risk and change well.
⎯ Poor strategic fit – The two companies have strategies and objectives that are too
different and they conflict with one another.
⎯ Cultural and social differences – It has been said that most problems can be traced
to people’s problems. If the two companies have wide differences in culture then
synergy values can be very elusive.
Incomplete and inadequate due diligence – Due diligence is the “watch dog” within
the mergers and acquisitions processes and failure to let due diligence do its job
causes serious problems.
⎯ Integration issues– Integration is often poorly managed with little planning and
design leading to failure of implementation.
⎯ Paying too much – If synergies are not realized, then the premium paid to acquire
the target is never recouped.
⎯ Overly optimistic – If the acquiring company is too optimistic in its projections
about the target company then bad decisions would be made within the mergers and
acquisitions process.
QUESTION 10
Explain the meaning of the term “corporate control” and describe the various ways in
which a change of corporate control could occur.
Corporate control refers to the monitoring and direction of a corporation. This comes
into play when a firm’s internal governance (Board of directors) fails. Once this happens
a firms value reduces and chances are that the firm will be acquired and therefore
corporate control changes.
A change in corporate control can occur when two firms merge through:-
⎯ Acquisition – when one company purchases another and submerges that company
into its existing operations.
⎯ Dual class recapitalization – when one class of stock has greater voting rights and
therefore greater control of a corporation.
⎯ Proxy fight – when one group of shareholders gather votes to take control of the
board of directors of a corporation.
⎯ A leveraged buyout or managed buyout, when third parties or management buy
all of the stock of a corporation (going private transaction) typically financing the
purchase with debt financing and hereby bringing the acquired firm into its control.
QUESTION 11
Explain why synergy might exist when one company merges or takes over another.
Synergy might exist for several reasons:
• Economic efficiency gains
Gains might relate to economies of scale or scope. Economies of scale occur through
factors such as fixed operating costs being spread over larger production activities.
Equipment being used more efficiently with higher volumes of production or bulk
purchasing because of the big site hereby reducing costs. Economies of scope might
arise from reduced advertising and distribution costs when companies have
complementary resources. Economies of scale and scope relate mainly to horizontal
acquisitions and mergers. Economic efficiency gains may also occur with backward
or forward vertical integration that might reduce production costs as the “middle
man” is eliminated, improve control of essential raw materials or other resources
that are needed for production or avoid disputes with what were previously suppliers
or customers. Economic efficiency gains might also result from replacing inefficient
management as the result of a merger or takeover
• Financial synergy
Mergers will lead to a reduction in the cost of capital and risk. The variability of
returns of a combined entity is usually less than the weighted average of the risk of
the individual companies. However, reduced variability of returns might improve a
company’ credit rating making it easier and/or cheaper to obtain a loan. Another
possible financial synergy exists when one company in an acquisition or merger is
able to use tax shields or accumulated tax losses, which would otherwise have been
unavailable to the other company.
| • | Market power A large organization, particularly one that has acquired competitors might have |
sufficient market power to increase its profits through price leadership or other
monopolistic or oligopolistic means.
QUESTION 12
Describe how to predict that a company is an easy target for the purposes of acquisition
by the predator
– Prediction of Takeover target
Several explanations which attempts to describe how to predict this company is an
easy target for the purposes of acquisition by the predator.
– The growth resource mismatch hypothesis
This is where a company has high potential for growth but no capital resources. It
becomes an easy target for a predictor with excess resources.
– Industrial disturbance hypothesis
It is where firms in a given industry are experiencing economic problems. Technology
changes regulations by the government inflation rates, increased competition etc.
mergers and acquisition may make firms of a given industry to be under distress
and good targets of acquisition by other firms in other industries.The inefficient management team hypothesis
This is where the management team of the company. is inefficient. In this case the
predator will take over the company in order to increase the productivity and improve
the utilization of the resources.
| – | The size effect hypothesis |
| Large | firms can easily take over the small firms since it’s easier to absorb their |
transaction costs.
QUESTION 13
Explain two circumstances under which dilution of earnings might be acceptable to the
shareholders of one of the companies in a take-over deal.
The cases where some dilution of earnings might be acceptable to one of the
parties in take-over are:
– Where although earnings per share are reduced, the asset per share is increases.
Where this happens then the increased asset backing may compensate for the loss
in earnings in maintaining the market price of the shares; and the asset themselves
may either serve as a basis for capital gearing (thus possibly restore the EPS in the
long-run) or may be realized and the proceeds re-invested to restore the earnings
position.
– Where a company with generally high but erratic earnings acquires a company yet
with lower but stable earnings per share i.e. the ‘quality’ of the earning share
improved, and this could in fact lead to an improvement in the P/E ratio.
