Topic: Acquisitions and mergers versus other growth strategies

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  • 8 Marks

AFM – Nov 2018 – L3 – Q3a – Acquisitions and mergers versus other growth strategies

Discuss when takeovers make financial and economic sense and reasons why takeovers may fail to increase shareholder wealth.

Despite substantial evidence, drawn from different countries and different time periods, that suggests the wealth of shareholders in a bidding company is unlikely to be increased as a result of taking over another company, takeovers remain an important part of the business landscape.

Required:
i) Explain briefly when a takeover will make economic and financial sense.
(3 marks)

ii) Discuss briefly FIVE (5) reasons why a takeover may fail to deliver an expected increase in wealth for the bidding company’s shareholders.
(5 marks)

i) When a takeover makes economic and financial sense
A takeover makes economic and financial sense when it creates value through synergies. The value of the combined business must exceed the sum of the values of the individual businesses. This can be expressed as:

PV Combined business > PV Bidding business + PV Target business

This means that the takeover should generate benefits such as cost savings, revenue enhancement, or improved efficiency, which would not have been realized if the companies operated independently. The combined entity should deliver a higher net present value (NPV) or enhanced future cash flows, justifying the merger or acquisition.
(3 marks)

ii) Five reasons why a takeover may fail to deliver the expected increase in wealth for the bidding company’s shareholders

  1. Overpayment for the target company:
    Management of the bidding company may pay too much for the target company. Often, a premium is paid to convince shareholders of the target to sell their shares. This premium might not be justified by the future gains from the merger, leading to wealth transfer from the bidding company’s shareholders to the target’s shareholders.
  2. Hidden problems in the target company:
    Problems that were hidden or undiscovered during the due diligence process may emerge after the acquisition. These issues could be financial, operational, or legal, and they may erode the anticipated benefits from the takeover.
  3. Integration challenges:
    Integrating the operations, culture, and management of the two companies may prove difficult. Differences in organizational cultures, management styles, and systems can lead to inefficiencies and prevent the realization of expected synergies.
  4. Management complacency:
    After the takeover, management may become complacent, believing that the takeover itself guarantees success. Without continuous effort to integrate and improve operations, the anticipated benefits may not materialize, leading to underperformance.
  5. Errors in valuing the target company:
    Misjudgment in valuing the target company may lead to the bidding company overpaying for the acquisition. This often results from incorrect assumptions about future cash flows or failure to account for the risk associated with the acquisition.
  • 5 Marks

AFM – May 2016 – L3 – Q3b – Acquisitions and mergers versus other growth strategies, Regulatory framework and processes

Outline the actions a target company might take to prevent a hostile takeover bid.

b) As a Finance Manager in your company, you have been asked to produce an explanatory memo to Senior Management on the subject of Mergers and Acquisitions. Your memo should clearly outline what actions a target company might take to prevent a hostile takeover bid.

(5 marks)

Memo: Hostile Takeover Defense Strategies

To: Senior Management
From: Finance Manager
Subject: Actions to Prevent a Hostile Takeover Bid

In response to concerns regarding the possibility of a hostile takeover, there are several strategies that a target company can adopt to defend against such attempts. Below are five key actions:

  1. White Knight
    • This involves finding a friendly third-party company (a “white knight”) that offers a more favorable acquisition deal to outbid the hostile company. This strategy allows the target company to avoid falling into the hands of the hostile bidder.
      (1 mark)
  2. Shark Repellent
    • Amending the company’s charter or bylaws to make it difficult for the acquiring company to complete a takeover. This can include raising the threshold for shareholder approval or implementing supermajority voting requirements.
      (1 mark)
  3. Pac-Man Defense
    • In this defense, the target company turns the tables by attempting to acquire the hostile company that is attempting the takeover. This often deters the hostile bidder, as it becomes the target of the acquisition instead.
      (1 mark)
  4. Golden Parachutes
    • This strategy involves providing the company’s top executives with generous severance packages that are triggered in the event of a takeover. This increases the cost of the acquisition, making it less attractive for the hostile bidder.
      (1 mark)
  5. Poison Pill
    • A tactic where the target company issues new shares to existing shareholders at a discount, making it more difficult and expensive for the acquiring company to buy a controlling stake in the business. This dilutes the ownership of the hostile bidder.
      (1 mark)
  • 10 Marks

AFM – May 2016 – L3 – Q3a – Valuation of acquisitions and mergers, Acquisitions and mergers versus other growth strategies

Calculate pre-acquisition market values of two companies and determine the maximum price for an acquisition.

a) Plainview Farms Limited is considering acquiring Cottage Industries Limited. The extracts of the financial statements of the two companies are as follows:

Statement of Financial Position

Plainview Farms Ltd (GH¢’m) Cottage Industries Ltd (GH¢’m)
Net Assets 6,300 1,892
Equity Capital 2,000 1,000
Income Surplus 4,300 892

Income Statement

Plainview Farms Ltd (GH¢’m) Cottage Industries Ltd (GH¢’m)
Profit after tax 800 300
Dividend (600) (100)
Retained earnings 200 200

The two companies retain the same proportion of profits each year, and this is expected to continue in the future. Plainview Farms Limited’s return on investment is 16%, while Cottage Industries Limited’s is 21%. One year after the post-acquisition period, Plainview Farms will retain 60% of its earnings and expects to earn a return of 20% on new investment.

The dividends of both companies have been paid. The required rate of return for ordinary shareholders of Plainview Farms Limited is 12%, and for Cottage Industries Limited it is 18%. After the acquisition, the required rate of return will become 16%.

Required:
i) Calculate the pre-acquisition market values of both companies. (5 marks)
ii) Calculate the maximum price Plainview Farms Limited will pay for Cottage Industries Limited. (5 marks)

  • 4 Marks

AFM – May 2018 – L3 – Q3a – Acquisitions and mergers versus other growth strategies

Discussing strategic issues that arise from pursuing growth through mergers, acquisitions, and organic growth.

Expansion by organic growth or by acquisition should only be undertaken if it leads to an increase in the wealth of the shareholders.

Required:
i) Discuss TWO strategic issues that arise from pursuing growth through mergers and acquisitions. (4 marks)
ii) Discuss TWO strategic issues that arise from pursuing growth through organic growth. (4 marks)

i) Strategic Issues in Mergers and Acquisitions:

  1. Time: Mergers or acquisitions allow a firm to increase its market share or enter a new market more quickly than if the firm tried to expand organically. Since “time is money,” the ability to enter a market or increase market share fast through mergers or acquisitions can be the cheapest way to expand.
  2. Cost: While cost savings can be achieved due to synergies, mergers or acquisitions may also be the most expensive way to expand due to the “premium for control.” Acquisitions might be expensive if they face resistance from target companies or government regulations under competition laws.
  3. Regulation/Legislation/Culture: Mergers or acquisitions can ease entry into markets with regulatory restrictions, but they might lead to cultural issues or backlash from local customers or governments.
  4. Assimilation and Integration: Integrating new employees, systems, and processes can lead to strains on the management, and handling a larger number of products or markets can cause “corporate indigestion.”

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