Computer Concepts and Computech Merger Analysis

Case 70

Computer Concepts/CompuTech

Merger Analysis

QUESTIONS

Question 1 Several factors have been proposed as providing a rationale for mergers. Among the more prominent ones are (1) tax considerations, (2) diversification, (3)

control, (4) purchase of assets below replacement cost, and (5) synergy. From the standpoint of society, which of these reasons are justifiable? Which are not? Why is such a question relevant to a company like CompuTech, which is considering a specific acquisition? Explain your answers.

Answer: Synergy is by far the most socially justifiable reason for mergers. Synergy occurs when the value of the combined enterprise exceeds the sum of the values of the pre-merger firms. (If synergy exists, the whole is greater than the sum of the parts, hence, synergy is often described as "2 + 2 = 5.")  A synergistic merger creates value, which must be allocated between the shareholders of the acquiring and the acquired firms. Synergy can arise from many sources, the most prominent being (1) operating economies of scale in management, production, marketing, or distribution; (2) financial economies, which could include higher debt capacity, lower transactions costs, or better coverage by securities' analysts which can lead to higher demand for the combined company's stock, and hence to higher stock prices; (3) differential managerial efficiency, which implies that a new management can increase the value of the firm's operating assets; and (4) increased market power due to reduced competition. Operating and financial economies are socially desirable, as are mergers that increase managerial efficiency, but mergers that reduce competition are undesirable, and antitrust laws are in place to prohibit such mergers.

If one agrees that our tax laws are reasonable, and that tax avoidance is reasonable, tax considerations represent a socially valid rationale for mergers. Without the merger, the unprofitable company might be able to use its tax carry-forwards eventually, but their value would be higher if used as the basis for a merger.

Merger motives that are questionable on economic grounds are diversification, purchase of assets below replacement cost, and control. Managers often state that diversification helps to stabilize a firm's earnings and reduces total risk, hence benefits shareholders. Stabilization of earnings is certainly beneficial to a firm's employees, suppliers, customers, and managers. However, if a stock investor is concerned about earnings variability, he or she can diversify more easily than the firm can. Why should Firm A and Firm B merge to stabilize earnings when stockholders can merely purchase both stocks and accomplish the same thing?  Further, we know that well-diversified shareholders are more concerned with a stock's market risk than with its total risk, and higher earnings instability does not necessarily translate into higher market risk.

Sometimes a firm will be touted as a possible acquisition candidate  because the replacement value of its assets is considerably higher than the firm's market value. For example, in the early 1980s, oil companies could acquire reserves more cheaply by buying out other oil companies than by exploratory drilling. However, the value of an asset stems from its expected cash flow, not from its cost. Thus, paying $1 million for a slide rule plant which would cost $2 million to build from scratch is not much of a deal if no one uses slide rules.

In recent years, many hostile takeovers have occurred. To keep their companies independent, and also to protect their jobs, managers sometimes engineer defensive mergers or leveraged managerial buyouts, which make their firms more difficult to digest.  In general, defensive mergers appear to be designed more for the benefit of managers than for that of stockholders.

It is important for managers to understand these points for at least three reasons:

(1) The managers of a firm thinking about making an acquisition must know how others, in general, tend to think about mergers in order to anticipate reactions to a proposed merger.

(2) Managers ought to question their own motives; especially, a company's directors ought to question management's motives if a merger is proposed.

(3) If antitrust issues are raised, the potential merger partners may have to justify the merger in the courts, and knowledge of both law and economics is essential at that point.

Question 2 Briefly describe the differences between a hostile merger and a friendly merger. Is there any reason to think that acquiring companies would, on average, pay a greater premium over target companies’ pre-announcement prices in hostile mergers than in friendly mergers?

Answer: In a friendly merger, the management of one firm agrees to be bought out by another firm. In most cases, the acquiring firm initiates the action, but in some situations the target may initiate the merger. The managements of both firms get together and work out terms which they believe to be fair and beneficial to both sets of shareholders. Then, they issue statements to their respective stockholders recommending that they agree to the merger. There is a chance that some other company may decide to make a competing bid and thwart the friendly merger, but barring such an offer, management's support normally assures that the outcome will be favorable.

If a target firm's management resists the merger, then the acquiring firm's advances are said to be hostile rather than friendly. In this case, the acquirer must make a direct appeal to the target firm's shareholders. This can take the form of (1) a tender offer, whereby the target firm's shareholders are asked to "tender" their shares to the acquiring firm in exchange for cash, stocks, bonds, or some combination of the three, or (2) a proxy fight. If 51 percent or more of the target shareholders tender their shares or vote for the acquirer, then the merger will probably be completed over management's objection. Though, that de facto, for tax and other reasons, it often takes more than 50 percent control to make a merger feasible, so management may be able to block a hostile takeover attempt with considerably less than 50 percent of the stock.

Presumably, in hostile situations the target firm's management makes every effort to get the best price for the company, whereas in a friendly merger management might be willing to see the company go for a low price so that they can get good positions in the surviving company. The motives and reasons are speculative, but evidence does show that larger premiums occur in hostile mergers.

Question 3 Complete CCI’s cash flow statements for 1996 through 1999. Why is interest expense typically deducted in merger cash flow statements, whereas it is not normally deducted in capital budgeting cash flow analysis? Why are retained earnings deducted to obtain the free cash flows?

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